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United States Government Accountability Office:
GAO:
Report to the Ranking Member, Committee on Financial Services, House
of Representatives:
May 2011:
Banking Regulation:
Enhanced Guidance on Commercial Real Estate Risks Needed:
GAO-11-489:
GAO Highlights:
Highlights of GAO-11-489, a report to the Ranking Member, Committee on
Financial Services, House of Representatives.
Why GAO Did This Study:
Since the onset of the financial crisis in 2008, commercial real
estate (CRE) loan delinquencies have more than doubled. The federal
banking regulators have issued statements and guidance encouraging
banks to continue lending to creditworthy borrowers and explaining how
banks can work with troubled borrowers. However, some banks have
stated that examiners’ treatment of CRE loans has hampered their
ability to lend. This report examines, among other issues, (1) how the
Federal Deposit Insurance Corporation (FDIC), Board of Governors of
the Federal Reserve System (Federal Reserve), and the Office of the
Comptroller of the Currency (OCC) responded to trends in CRE markets
and the controls they have for helping ensure consistent application
of guidance and (2) the relationships between bank supervision
practices and lending. GAO reviewed agency guidance, examination
review procedures, reports of examination, and relevant literature and
interviewed agency officials, examiners, bank officials, and academics.
What GAO Found:
Aware of the potential risks of growing CRE concentrations at
community banks, federal banking regulators issued guidance on loan
concentrations and risk management in 2006 and augmented it with
guidance and statements on meeting credit needs and conducting CRE
loan workouts from 2008 to 2010. The regulators also conducted
training on CRE treatment for examiners and internal reviews to help
ensure compliance with CRE guidance. Nevertheless, a number of banks
reported that examiners have been applying guidance more stringently
since the financial crisis and believe that they have been too harsh
in treatment of CRE loans. Regulators have incorporated lessons
learned from the crisis into their supervision approach, which may
help explain banks’ experiences of increased scrutiny. GAO found that
examiners generally provided support for exam findings on loan
workouts, but identified some inconsistencies in applying the 2006 CRE
concentration guidance-—which is similar to what some of the
regulators uncovered in their internal reviews. Moreover, regulatory
officials had varying views on the adequacy of the 2006 guidance, and
some examiners and bankers noted that the guidance lacked clarity on
how to comply with it. As a result, examiners and bankers may not have
a common understanding about CRE concentration risks.
Figure: Average CRE Concentration among Community Banks and Regulatory
Guidance:
[Refer to PDF for image: vertical bar graph]
Year: 1996;
CRE Concentration: 149.4%.
Year: 1997;
CRE Concentration: 156.7%.
Year: 1998;
CRE Concentration: 161.3%.
Year: 1999;
CRE Concentration: 180.3%.
Year: 2000;
CRE Concentration: 192.8%.
Year: 2001;
CRE Concentration: 212.4%.
Year: 2002;
CRE Concentration: 228.6%.
Year: 2003;
CRE Concentration: 244.5%.
Year: 2004;
CRE Concentration: 260.9%.
Year: 2005;
CRE Concentration: 278.2%.
Year: 2006;
CRE Concentration: 286.8%;
[Concentrations in Commercial Real Estate Lending, Sound Risk
Management Practices: 12/12/2006]
Year: 2007;
Owner-occupied properties: 76.9%;
CRE Concentration: 221.4%;
Year: 2008;
Owner-occupied properties: 95.8%;
CRE Concentration: 210.7%;
[Statement on Meeting the Needs of Creditworthy Borrowers: 11/12/2008]
Year: 2009;
Owner-occupied properties: 96.4%;
CRE Concentration: 197.2%;
[Policy Statement on Prudent Commercial Real Estate Loan Workouts:
10/30/2009]
Year: 2010;
Owner-occupied properties: 93.4%;
CRE Concentration: 175.1%;
[Statement on Meeting the Credit Needs of Creditworthy Small Business
Borrowers: 2/5/2001]
Source: GAO analysis of data from FDIC and regulatory guidance.
[End of figure]
Although many factors influence banks’ lending decisions, research
shows that the capital banks hold is a key factor. Capital provides an
important cushion against losses, but if a bank needs to increase it,
the cost of raising capital can raise the cost of providing loans.
High CRE concentrations also can limit a bank’s ability to lend
because the bank may need to raise capital to mitigate the
concentration risk during a downturn. Economic research on the effect
of regulators’ examination practices on banks’ lending decisions is
limited, but shows that examiners’ increased scrutiny during credit
downturns can have a small impact on overall lending. Although
isolating these impacts is difficult, the recent severe cycle of
credit upswings followed by the downturn provides a useful reminder of
the balance needed in bank supervision to help ensure the banking
system can support economic recovery.
What GAO Recommends:
Federal banking regulators should enhance or supplement the 2006 CRE
concentration guidance and take steps to better ensure that such
guidance is consistently applied. The Federal Reserve and OCC agreed
with the recommendations. FDIC said that it had implemented strategies
to supplement the 2006 guidance.
View [hyperlink, http://www.gao.gov/products/GAO-11-489] or key
components. For more information, contact A.Nicole Clowers at (202)
512-8678 or clowersa@gao.gov.
[End of section]
Contents:
Letter:
Background:
Deterioration of the CRE Market Negatively Affected Community Banks,
Which Could Impact Small Business Lending:
While Regulators Have Taken Steps to Address CRE Concentrations and
Bank Concerns, Challenges Remain in Consistently Applying Guidance:
Multiple Factors Can Affect Banks' Lending Decisions, Including
Regulators' Actions:
Conclusions:
Recommendations for Executive Action:
Agency Comments and Our Evaluation:
Appendix I: Scope and Methodology:
Appendix II: ALLL and Loan Loss Impact on Capital:
Appendix III: Comments from the Federal Deposit Insurance Corporation:
Appendix IV: Comments from the Board of Governors of the Federal
Reserve System:
Appendix V: Comments from the Office of the Comptroller of the
Currency:
Appendix VI: GAO Contact and Staff Acknowledgments:
Tables:
Table 1: Regulatory Overview Information for FDIC, the Federal
Reserve, and OCC (as of December 31, 2010):
Table 2: CAMELS Composite Score Definitions:
Table 3: Regulatory Loan Classification System:
Table 4: Key CRE Property Types:
Table 5: Sample Selection by Regulator for ROE Analysis:
Table 6: Sample Selection by State for ROE Analysis:
Table 7: Sample Selection by CAMELS Composite Rating for ROE Analysis:
Table 8: Locations of Banks Whose Officials We Interviewed:
Figures:
Figure 1: Trends in Commercial Property Price Index (from 2002 through
2010):
Figure 2: Average CRE Concentrations at Community Banks (from 1996
through 2010):
Figure 3: Percent of Noncurrent Loans Secured by CRE at Community
Banks (from 2000 through 2010):
Figure 4: Average Charge-off Rate for Loans Secured by CRE at
Community Banks (from 2000 through 2010):
Figure 5: The Community Bank Examination Review Process at FDIC, the
Federal Reserve, and OCC:
Figure 6: Illustration of How ALLL and Loan Losses Can Affect Capital
Ratios on a Bank's Balance Sheet:
Abbreviations:
ABA: American Bankers Association:
ADC: acquisition, development, and construction:
ALLL: allowance for loan and lease loss:
CAMELS: Capital adequacy, Asset quality, Management, Earnings,
Liquidity, and Sensitivity:
CLD: construction and land development:
CMBS: commercial mortgage-backed securities:
CRE: commercial real estate:
EIC: examiner-in-charge:
FASB: Financial Accounting Standards Board:
FDIC: Federal Deposit Insurance Corporation:
Federal Reserve: Board of Governors of the Federal Reserve System:
FFIEC: Federal Financial Institutions Examination Council:
ICBA: Independent Community Bankers of America:
IG: inspector general:
MLR: material loss reviews:
MRA: matter requiring attention:
NCUA: National Credit Union Administration:
OCC: Office of the Comptroller of the Currency:
OTS: Office of Thrift Supervision:
ROE: report of examination:
TDR: troubled debt restructuring:
[End of section]
United States Government Accountability Office:
Washington, DC 20548:
May 19, 2011:
The Honorable Barney Frank:
Ranking Member:
Committee on Financial Services:
House of Representatives:
Dear Mr. Frank:
The financial crisis, and the economic downturn that followed it,
largely arose out of problems related to the residential mortgage
sector, but the commercial real estate (CRE) market also has
experienced significant setbacks, that in turn, have affected
community banks.[Footnote 1] More than a third of community bank
lending is tied to CRE, and delinquencies for such loans have more
than doubled since 2008. While segments of the CRE market have shown
some improvement, problems in CRE lending are expected to continue,
and refinancing such loans could present further challenges to the
market in coming years. Banks are addressing these problems in many
ways, including modifying borrowers' loan terms so that they can
continue to make payments, increasing bank capital and reserves as
protection against future losses, and, in some cases, reducing
lending.[Footnote 2] However, reduced lending to creditworthy
borrowers can exacerbate credit tightening and inhibit economic
recovery.
The federal banking regulators have been monitoring the increasing CRE
concentrations for a number of years and have responded to the current
CRE downturn and its impact on the banks they supervise. The
regulators have issued interagency statements and guidance--most
recently from 2006 through 2010--on managing the risks of CRE
concentrations, encouraging banks to continue lending to creditworthy
borrowers, clarifying to banks how examiners will review loans secured
by CRE, and explaining how banks can work with troubled borrowers.
[Footnote 3] Regulators have also noted concerns they have about the
risk-management systems of banks with high CRE concentrations and have
"classified" more loans (that is, identified loans that pose a risk of
loss to banks).[Footnote 4] In doing so, examiners have been
criticized by some in the banking industry for being too harsh in
their treatment of CRE loans in banks' portfolios, and some argue that
this has hampered lending more broadly in communities across the
country.
In light of these questions about examiners' treatment of CRE loans,
you asked us to review whether examiners' practices related to CRE
were consistent with recent regulatory statements and guidance;
whether regulatory views on regulators' bank ratings, capital, and
liquidity have changed; and what the potential impact of regulatory
practices might be on lending by community banks. This report examines
(1) the condition of the CRE market and the implications for community
banks; (2) how three federal banking regulators--the Federal Deposit
Insurance Corporation (FDIC), Board of Governors of the Federal
Reserve System (Federal Reserve), and the Office of the Comptroller of
the Currency (OCC)--responded to trends in CRE markets through their
supervision of community banks and what controls they have to help
ensure consistent application of policy guidance; and (3) what is
known about the relationships between bank supervision practices and
lending.
To address our objectives related to the condition of the CRE market
and its implications for community banks, we analyzed data from 1996
through 2010 (when available) from Moody's/REAL Commercial Property
Price Index for CRE values and call report data for CRE loan
concentrations and performance.[Footnote 5] We reviewed CRE-related
reports from the Congressional Oversight Panel, Congressional Research
Service, FDIC, Federal Reserve, and academic journals, and conducted
interviews with bank examiners, regulatory officials, and community
bankers. We also examined material loss reviews (MLR) conducted by the
inspectors general (IG) of the bank regulators and previous GAO
products. To understand how FDIC, the Federal Reserve, and OCC have
responded to the CRE downturn, we collected and analyzed regulatory
guidance related to CRE loan treatment and interagency statements on
lending, and also assessed regulatory efforts to address CRE-related
concerns.[Footnote 6] As part of this work, we observed training
provided by the Federal Financial Institutions Examination Council
(FFIEC) to examiners related to CRE guidance and loan classifications.
[Footnote 7]
To understand bank officials' concerns about examiners' treatment of
CRE loans, we spoke with officials from 43 community banks and
analyzed 55 bank reports of examination (ROE). For our bank official
interviews, we contacted 62 banks and spoke with all 21 that responded
to us based on a nonprobability sample of banks in California,
Georgia, Massachusetts, and Texas. We chose those states because banks
in the first two states have had a relatively greater share of CRE-
related nonperforming loans (as measured by the percentage of CRE
loans past due or on nonaccrual) and banks in the last two a
relatively smaller share.[Footnote 8] From these states, we selected
banks that had a federal bank regulator examination after October
2009; elevated concentrations in CRE; or elevated concentrations in
acquisition, development, and construction (ADC) loans.[Footnote 9]
This sampling approach also was used to select the 55 ROEs for
analysis. Our sample is not designed to be generalizable to all banks,
but instead provides information on a range of banks working under
different supervisors, having different conditions, and operating in
different economic environments. For our bank official interviews, we
supplemented the sample by interviewing officials from 22 additional
banks that testified before Congress on the issue of CRE, were
identified through bank associations, or requested an interview after
learning about our work.
To understand examiners' practices and views on certain regulatory
measures, especially on the CRE loan workout guidance, we spoke with
regulatory staff at district, regional, and field offices in
California, Colorado, Georgia, Massachusetts, and Texas, and in
headquarters at Washington, D.C. We spoke with more than 230 field
staff in various roles (either directly involved in drafting and
reviewing ROEs or participating in oversight of the review process)--
both in group settings and individually. While not representative of
the population of examiners and regulatory staff, our interviews with
examiners and other regulatory staff provide a broad range of views.
To understand the controls the regulators have in place to help ensure
consistent application of policy guidance, we collected, compared, and
analyzed examination review reports and quality assurance processes
for the three regulators, and also interviewed officials. To
understand what is known about the relationships between regulators'
supervision practices, lending, and CRE values, we conducted a
literature review dating to 1991 and focusing on comprehensive,
empirical, published research that reviewed such topics and also
interviewed academics, regulatory officials, and bank officials.
We conducted this performance audit from May 2010 through May 2011 in
accordance with generally accepted government auditing standards.
Those standards require that we plan and perform the audit to obtain
sufficient, appropriate evidence to provide a reasonable basis for our
findings and conclusions based on our audit objectives. We believe
that the evidence obtained provides a reasonable basis for our
findings and conclusions based on our audit objectives.[Footnote 10]
Background:
As of December 31, 2010, there were 6,364 community banks (commercial
banks with total assets of $1 billion or less). This represents about
92 percent of all commercial banks, although only about 10 percent of
commercial bank assets nationwide.
Banks in the United States are supervised by one of the following
three federal regulators:
* FDIC supervises all FDIC-insured state-chartered banks that are not
members of the Federal Reserve System.
* The Federal Reserve supervises commercial banks that are state-
chartered and members of the Federal Reserve System.
* OCC supervises federally chartered national banks.
Table 1 summarizes the regulators' oversight responsibilities for
community banks.
Table 1: Regulatory Overview Information for FDIC, the Federal
Reserve, and OCC (as of December 31, 2010):
Regulator: Federal Reserve;
Bank type supervised: State-chartered member banks of Federal Reserve
System;
Number of banks supervised: 829;
Number of community banks (less than $1 billion total assets)
supervised: 729;
Total assets under supervision: $1.697 billion;
Total assets under supervision at banks with less than $1 billion in
total assets: $167.2 million.
Regulator: FDIC;
Bank type supervised: State nonmember banks;
savings institutions;
Number of banks supervised: 4,715;
Number of community banks (less than $1 billion total assets)
supervised: 4,414;
Total assets under supervision: $2.259 billion;
Total assets under supervision at banks with less than $1 billion in
total assets: $865.4 million.
Regulator: OCC;
Bank type supervised: Federally chartered national banks;
Number of banks supervised: 1,383;
Number of community banks (less than $1 billion total assets)
supervised: 1,221;
Total assets under supervision: $8.432 billion;
Total assets under supervision at banks with less than $1 billion in
total assets: $267.7 million.
Regulator: Total;
Number of banks supervised: 6,927;
Number of community banks (less than $1 billion total assets)
supervised: 6,364;
Total assets under supervision: $12.388 billion;
Total assets under supervision at banks with less than $1 billion in
total assets: $1.300 billion.
Source: GAO analysis of FDIC call report data.
[End of table]
The purpose of federal banking supervision is to help ensure that
banks throughout the financial system are operating in a safe and
sound manner, and are complying with banking laws and regulations in
the provision of financial services. As we have identified in previous
work, financial regulation more broadly has sought to achieve four
goals: to (1) ensure adequate consumer protections, (2) ensure the
integrity and fairness of markets, (3) monitor the safety and
soundness of institutions, and (4) act to ensure the stability of the
overall financial system.[Footnote 11] Federal banking regulators use
a number of tools to achieve these goals.
* Capital requirements: Regulators require banks to maintain certain
minimum capital requirements to help ensure the safety and soundness
of the banking system, and generally expect banks to hold capital
above these minimums--commensurate with their risks. Capital provides
an important cushion against losses for banks, and represents the
amount of money that can cover losses the bank may face related to
nonpayment of loans and other losses on assets. Capital can be
measured as total capital or tier 1 capital.[Footnote 12] Regulators
oversee the capital adequacy of their regulated institutions through
ongoing monitoring, including on-site examinations and off-site tools.
When regulators require banks to hold capital above regulatory
minimums, these requirements may result from an enforcement action
through an agreement between the regulator and the bank. However,
requiring banks to hold more capital may reduce the availability of
bank credit and reduce returns on equity to shareholders.
* Examinations and ratings: Federal banking laws and regulatory
guidance require on-site examinations, which serve to evaluate a
bank's overall risk exposure and its ability to identify and manage
those risks--especially as they affect a bank's financial health. At
each full-scope examination, examiners review the bank's risk exposure
on a number of components using what is known as the CAMELS rating
system (Capital adequacy, Asset quality, Management, Earnings,
Liquidity, and Sensitivity to market risk). Evaluations of CAMELS
components consider the institution's size and sophistication, the
nature and complexity of its activities, and its risk profile. In
examinations, a bank is rated for each of the CAMELS components and
given a composite rating, which generally bears a close relationship
to the component ratings. However, the composite is not an average of
the component ratings. The component rating and the composite ratings
are scored on a scale of 1 (best) to 5 (worst). Regulatory actions
typically correspond to the composite CAMELS ratings, with the actions
generally increasing in severity as the ratings become worse. Table 2
describes the definitions of the composite scores under the Uniform
Financial Institutions Rating System.[Footnote 13]
Table 2: CAMELS Composite Score Definitions:
Composite score: 1;
Definition: Banks in this group are sound in every respect and
generally have components rated 1 or 2. These banks are the most
capable of withstanding changing business conditions. These banks
exhibit the strongest performance and risk-management practices
relative to the bank's size, complexity, and risk profile and give no
cause for regulatory concern.
Composite score: 2;
Definition: Banks in this group are fundamentally sound and generally
should not have component ratings worse than 3. Only moderate
weaknesses are present and are within the bank's management
capabilities to correct. Risk-management practices are satisfactory
and there are no material regulatory concerns.
Composite score: 3;
Definition: Banks in this group exhibit some degree of regulatory
concern in one or more of the component areas. These banks exhibit a
combination of weaknesses that may range from weak to moderate and
management may lack the ability or willingness to effectively address
these weaknesses. These banks are generally less capable of
withstanding business fluctuations than 1 or 2 rated banks. Risk-
management practices may be less than satisfactory but failure appears
unlikely.
Composite score: 4;
Definition: Banks in this group generally exhibit unsafe and unsound
practices or conditions. There are serious financial or managerial
deficiencies that may range from severe to critically deficient. Banks
in this group are generally not capable of withstanding business
fluctuations. Risk-management practices generally are unacceptable
relative to the institution's size, complexity, and risk profile.
Failure is a distinct possibility if problems are not addressed and
resolved.
Composite score: 5;
Definition: Banks in this group exhibit extremely unsafe and unsound
practices or conditions; exhibit critically deficient performance;
often contain inadequate risk-management practices relative to the
bank's size, complexity, and risk profile; and are the greatest
regulatory concern.
Source: Federal Reserve.
[End of table]
* Loan classifications: In examinations, examiners review a sample of
banks' internal ratings of loans to determine the adequacy of credit
risk administration and identify loans that show undue risk and may be
uncollectible. As part of this review, examiners determine which loans
are considered "pass," with no concerns noted, as well as those that
are special mentioned or "classified"--that is, subject to criticism
because they are not performing or may not perform in the future.
There are three classification categories used by the federal banking
regulators: substandard, doubtful, and loss (see table 3). These loan
classifications, and the internal ratings that banks produce for all
of their loans, are incorporated into how each bank calculates its
allowance for loan and lease loss (ALLL), which is an estimate made
according to accounting guidance of incurred losses on loans and
leases.[Footnote 14] Therefore, if additional loans are classified
substandard or doubtful, this information is included in a bank's
updated ALLL estimates. If loans are classified loss, they are charged
off the bank's balance sheet.[Footnote 15]
Table 3: Regulatory Loan Classification System:
Classification: Substandard;
Definition: Loans that are inadequately protected by the current sound
worth and paying capacity of the obligor or of the collateral pledged,
if any. Loans so classified must have a well-defined weakness or
weaknesses that jeopardize the liquidation of the debt. They are
characterized by the distinct possibility that the bank will sustain
some loss if the deficiencies are not corrected.
Classification: Doubtful;
Definition: Loans that have all the weaknesses inherent in those
classified substandard with the added characteristic that the
weaknesses make collection or liquidation in full, on the basis of
currently known facts, conditions, and values, highly questionable and
improbable.
Classification: Loss;
Definition: Loans that are considered uncollectible and of such little
value that their continuance as bankable assets is not warranted. This
classification does not mean that the loan has absolutely no recovery
or salvage value but rather it is not practical or desirable to defer
writing off this basically worthless asset even though partial
recovery may be effected in the future.
Source: Federal Reserve.
[End of table]
The end result of an on-site examination is an ROE that includes the
CAMELS ratings and other findings on the bank's condition, which is
provided to the bank's management and board of directors.
CRE Property Types and Associated Risks:
CRE encompasses many different property types that present different
risks. Table 4 describes the key CRE property types.
Table 4: Key CRE Property Types:
Property types: Retail;
Definition: Malls, major retailers, strip malls and small, local
retail businesses. These properties depend on the cash flow of the
resident businesses and are closely tied to consumer demand and the
overall economy.
Property types: Hotel/tourist;
Definition: All types of hotel and motel properties. These properties'
cash flows depend on levels of occupancy and the daily rate charged.
In addition to being tied to trends in tourism and the overall
economy, the hotel sector also is vulnerable to fluctuations in local
economies and conditions.
Property types: Office buildings;
Definition: Includes diverse properties in which office occupancy is
the dominant use. Office properties may be more stable due to their
longer lease cycles than other CRE property types.
Property types: Industrial;
Definition: Warehouses, manufacturing plants, light industrial plants,
laboratories, and research properties.
Property types: Multifamily housing and apartments;
Definition: Buildings with multiple dwelling units for rent. These
properties, unlike most residential properties, are income generating
and use the commercial mortgage market for financing.
Property types: Homebuilders;
Definition: The development of residential properties and loans to
businesses that develop residential properties.
Source: Congressional Oversight Panel (COP).
Note: This information is from the Congressional Oversight Panel's
February 10, 2010, report Commercial Real Estate Losses and the Risk
to Financial Stability.
[End of table]
Regulators define CRE loans to include construction loans, loans to
finance CRE that are not secured by CRE, loans secured by multifamily
property, and loans secured by nonfarm, nonresidential property in
which the primary source of repayment derives from the rental income
associated with the property or the proceeds of the sale, refinancing,
or permanent financing of the property. CRE loans in which the primary
source of repayment is not the property itself are called owner-
occupied loans and can include loans to businesses for working capital
purposes that use real estate as collateral.[Footnote 16] For example,
a line of credit for a business's operating expenses might be secured
in part by commercial property, such as an office.
Owner-occupied properties generally are considered to carry less risk
than non-owner-occupied properties because regulators consider them to
be less sensitive to the condition of the CRE market. In ADC loans,
also called construction and land development (CLD) loans, generally
are considered to be the riskiest class of CRE, due to their long
development times and because they can include properties (such as
housing developments or retail space in a shopping mall) that are
built before having firm commitments from buyers or lessees. In
addition, by the time the construction phase is completed, market
demand may have fallen, putting downward pressure on sales prices or
rents--making this type of loan more volatile. In recent years, this
type of loan also has tended to have a much higher loss volatility
than loans secured by properties such as multifamily housing and other
nonfarm, nonresidential commercial properties.
Banks report on four broad categories of CRE in their quarterly call
reports:
* CLD: loans secured by real estate to finance land development and
construction. This includes new construction, as well as additions and
alterations on existing properties.
* Multifamily: loans for residential properties with five or more
dwelling units, such as apartment buildings.
* Nonfarm nonresidential: loans secured by real estate for business
and industrial properties, as well as properties such as hotels,
churches, hospitals, schools, and charitable organizations. This
category includes offices, retail, and warehouse space.
* Loans to finance CRE, construction, and land development (not
secured by CRE).
Interagency guidance issued in 2006 on concentrations in CRE and sound
risk-management practices define CRE loans within these categories to
include those in which repayment is dependent on the cash flow
generated from the real estate itself. When evaluating concentrations
in CRE, examiners are instructed not to include owner-occupied
properties in which the income or value of the property is not the
primary source of repayment.
Deterioration of the CRE Market Negatively Affected Community Banks,
Which Could Impact Small Business Lending:
The CRE Market Has Experienced a Significant Downturn:
CRE as an asset class--and especially properties in the ADC category--
is prone to volatility and cyclical behavior, as illustrated in the
current CRE market downturn. This volatility and cyclical behavior is
attributed to characteristics such as information-gathering
difficulties, infrequent transactions, high transaction costs, rigid
and constrained supply, long construction times, and a two-fold
reliance on external finance (shorter-term to cover construction, and
longer-term for the occupancy period).[Footnote 17] Additionally, CRE
is by nature diverse and localized. For example, shopping centers are
one type of CRE, but even within this category properties can have
significant differences depending on design, types of tenants, and
other factors that can affect their value. Because of these factors,
the supply of CRE in the marketplace is slow to respond to an increase
in demand, which drives prices up when investor optimism rises.
Conversely, the marketplace is slow to respond when the market supply
of CRE catches up and new construction projects are delivered,
resulting in oversupply and declining property values. According to
regulatory officials, the weakness in the ADC sector during this
crisis was primarily due to residential housing construction, and that
weakness affected the performance of other areas of CRE (for example,
failed residential housing developments will affect the ability of
nearby strip malls to attract and generate rental income from tenants).
The recent downturn in the CRE markets can be seen in the market
values for commercial property and the condition of the commercial
mortgage-backed securities (CMBS) market.[Footnote 18] Market values
for all major commercial property types have declined significantly.
As of December 2010, overall CRE market values were down more than 42
percent from their peak in 2007. This decline followed a rapid
appreciation in CRE asset values during which CRE values increased by
more than 85 percent from 2002 to the market's peak in October 2007
(see figure 1). Overall deterioration in CRE markets can be found in
the condition of the CMBS market as well. By January 2011, the
delinquency rate on loans included in CMBS was at a record high, above
9 percent. As we have reported, overall CMBS issuance slowed severely
since the CRE downturn started. After peaking in 2007, the CMBS market
came to a complete halt by the end of 2008.[Footnote 19]
Figure 1: Trends in Commercial Property Price Index (from 2002 through
2010):
[Refer to PDF for image: line graph]
January 2002:
Moody’s/REAL Commercial Property Price Index: 1.03382.
February 2002:
Moody’s/REAL Commercial Property Price Index: 1.01771.
March 2002:
Moody’s/REAL Commercial Property Price Index: 1.01816.
April 2002:
Moody’s/REAL Commercial Property Price Index: 1.02342.
May 2002:
Moody’s/REAL Commercial Property Price Index: 1.03576.
June 2002:
Moody’s/REAL Commercial Property Price Index: 1.0518.
July 2002:
Moody’s/REAL Commercial Property Price Index: 1.05786.
August 2002:
Moody’s/REAL Commercial Property Price Index: 1.0682.
September 2002:
Moody’s/REAL Commercial Property Price Index: 1.08324.
October 2002:
Moody’s/REAL Commercial Property Price Index: 1.1045.
November 2002:
Moody’s/REAL Commercial Property Price Index: 1.11236.
December 2002:
Moody’s/REAL Commercial Property Price Index: 1.12428.
January 2003:
Moody’s/REAL Commercial Property Price Index: 1.13584.
February 2003:
Moody’s/REAL Commercial Property Price Index: 1.13297.
March 2003:
Moody’s/REAL Commercial Property Price Index: 1.12844.
April 2003:
Moody’s/REAL Commercial Property Price Index: 1.14627.
May 2003:
Moody’s/REAL Commercial Property Price Index: 1.14843.
June 2003:
Moody’s/REAL Commercial Property Price Index: 1.14761.
July 2003:
Moody’s/REAL Commercial Property Price Index: 1.16016.
August 2003:
Moody’s/REAL Commercial Property Price Index: 1.15243.
September 2003:
Moody’s/REAL Commercial Property Price Index: 1.16052.
October 2003:
Moody’s/REAL Commercial Property Price Index: 1.17424.
November 2003:
Moody’s/REAL Commercial Property Price Index: 1.18882.
December 2003:
Moody’s/REAL Commercial Property Price Index: 1.20396.
January 2004:
Moody’s/REAL Commercial Property Price Index: 1.21075.
February 2004:
Moody’s/REAL Commercial Property Price Index: 1.23835.
March 2004:
Moody’s/REAL Commercial Property Price Index: 1.26039.
April 2004:
Moody’s/REAL Commercial Property Price Index: 1.26914.
May 2004:
Moody’s/REAL Commercial Property Price Index: 1.2752.
June 2004:
Moody’s/REAL Commercial Property Price Index: 1.27776.
July 2004:
Moody’s/REAL Commercial Property Price Index: 1.32175.
August 2004:
Moody’s/REAL Commercial Property Price Index: 1.33385.
September 2004:
Moody’s/REAL Commercial Property Price Index: 1.34659.
October 2004:
Moody’s/REAL Commercial Property Price Index: 1.37283.
November 2004:
Moody’s/REAL Commercial Property Price Index: 1.38539.
December 2004:
Moody’s/REAL Commercial Property Price Index: 1.4005.
January 2005:
Moody’s/REAL Commercial Property Price Index: 1.45451.
February 2005:
Moody’s/REAL Commercial Property Price Index: 1.46699.
March 2005:
Moody’s/REAL Commercial Property Price Index: 1.5036.
April 2005:
Moody’s/REAL Commercial Property Price Index: 1.51287.
May 2005:
Moody’s/REAL Commercial Property Price Index: 1.54277.
June 2005:
Moody’s/REAL Commercial Property Price Index: 1.56263.
July 2005:
Moody’s/REAL Commercial Property Price Index: 1.58314.
August 2005:
Moody’s/REAL Commercial Property Price Index: 1.6162.
September 2005:
Moody’s/REAL Commercial Property Price Index: 1.62764.
October 2005:
Moody’s/REAL Commercial Property Price Index: 1.61632.
November 2005:
Moody’s/REAL Commercial Property Price Index: 1.62886.
December 2005:
Moody’s/REAL Commercial Property Price Index: 1.60636.
January 2006:
Moody’s/REAL Commercial Property Price Index: 1.66567.
February 2006:
Moody’s/REAL Commercial Property Price Index: 1.6936.
March 2006:
Moody’s/REAL Commercial Property Price Index: 1.69193.
April 2006:
Moody’s/REAL Commercial Property Price Index: 1.66103.
May 2006:
Moody’s/REAL Commercial Property Price Index: 1.68323.
June 2006:
Moody’s/REAL Commercial Property Price Index: 1.70244.
July 2006:
Moody’s/REAL Commercial Property Price Index: 1.68103.
August 2006:
Moody’s/REAL Commercial Property Price Index: 1.68241.
September 2006:
Moody’s/REAL Commercial Property Price Index: 1.68536.
October 2006:
Moody’s/REAL Commercial Property Price Index: 1.70515.
November 2006:
Moody’s/REAL Commercial Property Price Index: 1.70782.
December 2006:
Moody’s/REAL Commercial Property Price Index: 1.74085.
January 2007:
Moody’s/REAL Commercial Property Price Index: 1.79245.
February 2007:
Moody’s/REAL Commercial Property Price Index: 1.83466.
March 2007:
Moody’s/REAL Commercial Property Price Index: 1.85204.
April 2007:
Moody’s/REAL Commercial Property Price Index: 1.86369.
May 2007:
Moody’s/REAL Commercial Property Price Index: 1.8559.
June 2007:
Moody’s/REAL Commercial Property Price Index: 1.87248.
July 2007:
Moody’s/REAL Commercial Property Price Index: 1.88175.
August 2007:
Moody’s/REAL Commercial Property Price Index: 1.91112.
September 2007:
Moody’s/REAL Commercial Property Price Index: 1.88888.
October 2007:
Moody’s/REAL Commercial Property Price Index: 1.9187.
November 2007:
Moody’s/REAL Commercial Property Price Index: 1.91403.
December 2007:
Moody’s/REAL Commercial Property Price Index: 1.88514.
January 2008:
Moody’s/REAL Commercial Property Price Index: 1.87311.
February 2008:
Moody’s/REAL Commercial Property Price Index: 1.91241.
March 2008:
Moody’s/REAL Commercial Property Price Index: 1.86924.
April 2008:
Moody’s/REAL Commercial Property Price Index: 1.81227.
May 2008:
Moody’s/REAL Commercial Property Price Index: 1.74972.
June 2008:
Moody’s/REAL Commercial Property Price Index: 1.69276.
July 2008:
Moody’s/REAL Commercial Property Price Index: 1.6996.
August 2008:
Moody’s/REAL Commercial Property Price Index: 1.69741.
September 2008:
Moody’s/REAL Commercial Property Price Index: 1.73917.
October 2008:
Moody’s/REAL Commercial Property Price Index: 1.69764.
November 2008:
Moody’s/REAL Commercial Property Price Index: 1.63996.
December 2008:
Moody’s/REAL Commercial Property Price Index: 1.60463.
January 2009:
Moody’s/REAL Commercial Property Price Index: 1.5158.
February 2009:
Moody’s/REAL Commercial Property Price Index: 1.50631.
March 2009:
Moody’s/REAL Commercial Property Price Index: 1.48072.
April 2009:
Moody’s/REAL Commercial Property Price Index: 1.35309.
May 2009:
Moody’s/REAL Commercial Property Price Index: 1.25044.
June 2009:
Moody’s/REAL Commercial Property Price Index: 1.23816.
July 2009:
Moody’s/REAL Commercial Property Price Index: 1.1756.
August 2009:
Moody’s/REAL Commercial Property Price Index: 1.14061.
September 2009:
Moody’s/REAL Commercial Property Price Index: 1.09609.
October 2009:
Moody’s/REAL Commercial Property Price Index: 1.07981.
November 2009:
Moody’s/REAL Commercial Property Price Index: 1.09104.
December 2009:
Moody’s/REAL Commercial Property Price Index: 1.13577.
January 2010:
Moody’s/REAL Commercial Property Price Index: 1.14733.
February 2010:
Moody’s/REAL Commercial Property Price Index: 1.11698.
March 2010:
Moody’s/REAL Commercial Property Price Index: 1.11161.
April 2010:
Moody’s/REAL Commercial Property Price Index: 1.13095.
May 2010:
Moody’s/REAL Commercial Property Price Index: 1.17219.
June 2010:
Moody’s/REAL Commercial Property Price Index: 1.12515.
July 2010:
Moody’s/REAL Commercial Property Price Index: 1.08984.
August 2010:
Moody’s/REAL Commercial Property Price Index: 1.05371.
September 2010:
Moody’s/REAL Commercial Property Price Index: 1.09947.
October 2010:
Moody’s/REAL Commercial Property Price Index: 1.11413.
November 2010:
Moody’s/REAL Commercial Property Price Index: 1.12124.
December 2010:
Moody’s/REAL Commercial Property Price Index: 1.11158.
Source: Moody’s/REAL Commercial Property Price Index.
[End of figure]
Although CRE market price deterioration appears to have leveled off
recently, vacancies at many properties remain high and signs of a
market recovery have been uneven in different areas of the country.
High-value properties in markets such as New York, Washington, San
Francisco, and Boston have performed well more recently.[Footnote 20]
But low rental rates and high vacancies indicate that demand for
office, retail, multifamily housing, and warehouse space remains
relatively weak.[Footnote 21] Furthermore, although CRE markets
nationally have experienced a downturn, some regions have experienced
more distress than others. For example, the CRE markets in the South,
Midwest, and West have experienced greater stress and deterioration
than the East.[Footnote 22] These areas that have experienced greater
CRE market stress also have experienced more bank failures, according
to FDIC data.
The Decline of the CRE Market Has Adversely Affected Community Banks:
Community banks increasingly have moved toward providing CRE loans
more than other kinds of loan products, in part because of competitive
pressures. During the last decade, large banks and other financial
institutions increased their market share for consumer loans, credit
cards, and residential mortgages. As a result, community banks shifted
their focus to CRE lending. Some market observers argue that community
banks' focus on CRE lending, and, therefore, the long-term trend of
increased CRE concentrations, came about because community banks
generally know their local CRE markets better than larger banks and
are well-positioned to gather location-specific information for CRE
properties.
The increased exposure of community banks to CRE loans has been
pronounced over the last 10-15 years. While CRE collateral backed
about 30 percent of total loans and leases at community banks in 2000,
a decade later that rate increased to more than 43 percent.
Concentrations have been less pronounced at larger banks, which tend
to rely less heavily on CRE lending. Since 2000, CRE as a percent of
total loans and leases has ranged from about 15 percent to about 21
percent at commercial banks with more than $1 billion in total assets.
Community banks also have come to hold large concentrations of CRE
loans in comparison to their total capital. The average CRE
concentration at community banks as a percentage of total risk-based
capital increased from about 168 percent in 1996-2000 to about 289
percent in 2005-2010 (see figure 2).
Figure 2: Average CRE Concentrations at Community Banks (from 1996
through 2010):
[Refer to PDF for image: vertical bar graph]
Year: 1996;
CRE Concentration: 149.4%.
Year: 1997;
CRE Concentration: 156.7%.
Year: 1998;
CRE Concentration: 161.3%.
Year: 1999;
CRE Concentration: 180.3%.
Year: 2000;
CRE Concentration: 192.8%.
Year: 2001;
CRE Concentration: 212.4%.
Year: 2002;
CRE Concentration: 228.6%.
Year: 2003;
CRE Concentration: 244.5%.
Year: 2004;
CRE Concentration: 260.9%.
Year: 2005;
CRE Concentration: 278.2%.
Year: 2006;
CRE Concentration: 286.8%.
Year: 2007;
Owner-occupied properties: 76.9%;
CRE Concentration: 221.4%;
Year: 2008;
Owner-occupied properties: 95.8%;
CRE Concentration: 210.7%.
Year: 2009;
Owner-occupied properties: 96.4%;
CRE Concentration: 197.2%.
Year: 2010;
Owner-occupied properties: 93.4%;
CRE Concentration: 175.1%.
Quarterly data for 2008-2010:
2008: Q1;
Owner-occupied properties: 89%;
CRE Concentration: 211.7%.
2008: Q2;
Owner-occupied properties: 91.2%;
CRE Concentration: 211.2%.
2008: Q3;
Owner-occupied properties: 93.8%;
CRE Concentration: 210.3%.
2008: Q4;
Owner-occupied properties: 97%;
CRE Concentration: 209.4%.
2009: Q1;
Owner-occupied properties: 97.5%;
CRE Concentration: 202.7%.
2009: Q2;
Owner-occupied properties: 99.1%;
CRE Concentration: 200.5%.
2009: Q3;
Owner-occupied properties: 99.6%;
CRE Concentration: 194.1%.
2009: Q4;
Owner-occupied properties: 102.2%;
CRE Concentration: 191.4%.
2010: Q1;
Owner-occupied properties: 101.6%;
CRE Concentration: 184%.
2010: Q2;
Owner-occupied properties: 101.3%;
CRE Concentration: 177%.
2010: Q3;
Owner-occupied properties: 99.8%;
CRE Concentration: 171.3%.
2010: Q4;
Owner-occupied properties: 100.5%;
CRE Concentration: 168%.
Source: GAO analysis of data from FDIC.
Note: The CRE concentrations represented in this graphic include loans
secured by owner-occupied CRE. Call report data did not begin
specifying whether CRE was owner-occupied until 2007.
[End of figure]
Increased exposure to CRE has made community banks vulnerable to the
decline of this market. According to FDIC, nearly 30 percent of
community banks have concentrations of CRE to total capital above 300
percent, the concentration threshold established in the 2006
interagency guidance on CRE, above which regulators review banks' risk-
management controls more closely. This means that nearly a third of
community banks are exposing three times their total capital to risks
related to their CRE loans. As noted by a Bank for International
Settlements report on bank lending and commercial property cycles,
declining property prices increase the proportion of nonperforming
loans, lead to a deterioration in banks' balance sheets, and weaken
banks' capital bases.[Footnote 23] In particular, the decline in CRE
values has contributed to more noncurrent CRE loans, charge-offs, and
bank failures.
* Noncurrent CRE loans have increased. From the first quarter of 2008
through the fourth quarter of 2010, the percent of CRE loans at
community banks that were noncurrent increased from 2.2 to 5.3
percent, well above the average rate of 0.9 percent from 2000 through
2007. The average from 2000 through 2010 is 1.94 percent. However, the
data show that the volume of noncurrent CRE loans has begun to level
off (see figure 3).
Figure 3: Percent of Noncurrent Loans Secured by CRE at Community
Banks (from 2000 through 2010):
[Refer to PDF for image: 2 vertical bar graphs]
Annual average (2000-2010):
Average, 2000-2010: 1.94%.
Year: 2000;
Average: 0.68%.
Year: 2001;
Average: 0.92%.
Year: 2002;
Average: 0.9%.
Year: 2003;
Average: 0.83%.
Year: 2004;
Average: 0.63%.
Year: 2005;
Average: 0.57%.
Year: 2006;
Average: 0.72%.
Year: 2007;
Average: 1.65%.
Year: 2008;
Average: 3.68%.
Year: 2009;
Average: 5.39%.
Year: 2010;
Average: 5.32%.
Quarterly average (2008-2010):
2008: Q1;
Average: 2.22%.
2008: Q2;
Average: 2.63%.
2008: Q3;
Average: 3.02%.
2008: Q4;
Average: 3.68%.
2009: Q1;
Average: 4.24%.
2009: Q2;
Average: 4.79%.
2009: Q3;
Average: 5.17%.
2009: Q4;
Average: 5.39%.
2010: Q1;
Average: 5.54%.
2010: Q2;
Average: 5.4%.
2010: Q3;
Average: 5.37%.
2010: Q4;
Average: 5.32%.
Source: GAO analysis of data from FDIC.
[End of figure]
* CRE loan charge-offs increased. From the end of 2007 through the end
of 2010, the percent of CRE loans that had to be charged off at
community banks rose from 0.19 to 1.34 percent. From 2000 through
2007, the average charge off rate of CRE loans at community banks was
0.09 percent, and from 2000 through 2010 it was 0.39 percent (see
figure 4). Charge-offs and expected losses that may arise from
increases in noncurrent CRE loans have put stress on banks' capital
and ALLL.
Figure 4: Average Charge-off Rate for Loans Secured by CRE at
Community Banks (from 2000 through 2010):
[Refer to PDF for image: vertical bar graph]
Average: 0.39%.
Year: 2000;
Percentage: 0.04%.
Year: 2001;
Percentage: 0.09%.
Year: 2002;
Percentage: 0.11%.
Year: 2003;
Percentage: 0.1%.
Year: 2004;
Percentage: 0.07%.
Year: 2005;
Percentage: 0.04%.
Year: 2006;
Percentage: 0.05%.
Year: 2007;
Percentage: 0.19%.
Year: 2008;
Percentage: 0.74%.
Year: 2009;
Percentage: 1.51%.
Year: 2010;
Percentage: 1.34%.
Source: GAO analysis of data from FDIC.
[End of figure]
* Increased bank failures linked to high CRE and ADC concentrations.
Many bank failures are associated with high CRE and ADC
concentrations. In 2009 and 2010, 102 of 106 of the MLRs issued by the
IGs of the banking regulators cited high CRE concentrations, and 92 of
106 specifically cited ADC loans in particular as a contributing
factor in bank failures. In the 106 MLRs, 76 of the banks reviewed
were community banks.[Footnote 24] For example, the MLR for one failed
bank--which contains findings similar to many other MLRs we reviewed--
states that the rapid growth of its CRE portfolio "increased the
institution's exposure to a sustained downturn in the real estate
market and reduced its ability to absorb losses due to unforeseen
events."
Depressed CRE Markets Could Reduce Small Business Lending:
CRE market value declines could reduce overall small business lending
by community banks. As we previously reported, community banks tend to
have a larger portion of small-business related loans compared with
larger banks.[Footnote 25] Because CRE can be used as collateral for
small business loans, diminished CRE values also can negatively affect
credit availability to small businesses. Specifically, when the value
of collateral declines, the amount of financing a bank is willing to
lend against that collateral typically declines as well. Conversely,
increases in collateral values lower the premium on external financing-
-improving credit availability for borrowers, boosting demand for real
estate assets, and driving up prices. Therefore, falling property
prices can generate a cycle of declining CRE values because they can
accompany reduced credit. A report by the Bank for International
Settlements notes that falling CRE prices decrease the value of
collateral held by banks and, therefore, can give rise to significant
losses by these banks and ultimately contract the supply of credit.
[Footnote 26]
The problem of CRE loan refinancing may exacerbate the negative CRE
trends and limit lending to small businesses. CRE loans usually are
written for 3-10 years, with a 20-30 year amortization schedule and a
balloon payment at the end. Instead of making the large balloon
payment, the borrower typically will sell the property or refinance
the loan at the end of the term. Small businesses that are looking to
refinance a loan against a property that has lost a significant amount
of market value may have to put up more equity. Alternatively, such
borrowers might default on the loan, or the bank could work with the
borrower to restructure the loan and avoid default. Trepp LLC, a
commercial mortgage analysis firm, estimates that about $1.7 trillion
in CRE mortgages will mature between 2011 and 2015, with about half of
that held at banks. Moreover, Trepp estimates that approximately 60
percent of CRE debt maturing in 2011 is "underwater"--meaning the
value of the loan exceeds the value of the underlying collateral. Due
to price declines and stricter bank underwriting standards compared to
when these loans were originated, those mortgages will be difficult to
refinance.
Results from the Federal Reserve's Senior Loan Officer Opinion Survey
have suggested that new CRE borrowers have faced tighter credit
conditions, due to banks tightening their underwriting standards in
response to the downturn. The January 2011 survey found that 10.6
percent of respondents reported easing credit standards over the
previous 3 months, compared to 10.5 percent who reported tightening
them. However, this is a positive development from past results that
showed severe tightening.[Footnote 27] The trend of tighter credit
standards suggests that borrowers who previously were considered
creditworthy might not meet banks' higher standards.
While Regulators Have Taken Steps to Address CRE Concentrations and
Bank Concerns, Challenges Remain in Consistently Applying Guidance:
The regulators have been aware for some time of the risk-management
challenges related to growing CRE concentrations at community banks
and have taken steps to address these challenges. The regulators, for
example, issued guidance to banks on managing CRE concentration risks,
conducted training on CRE treatment, and conducted internal reviews to
better ensure examiner compliance with CRE guidance. Even with the
training and reviews, a number of bank officials we interviewed stated
that regulators have applied guidance rigidly since the financial
crisis and have been too harsh in classifying loans and improperly
applying the 2006 CRE guidance, among other issues. Regulators have
been incorporating lessons from the financial crisis in their
supervisory practices, which in part may explain bank officials'
experience of increased stringency in supervision. Based on our review
of a nonprobability sample of 55 bank examinations, examiners'
findings were consistent with CRE loan workout guidance, although in
some instances examiners did not clearly support requirements for
reduced CRE concentrations and did not calculate CRE concentrations
according to concentration and risk-management guidance. Additionally,
senior regulatory officials and examiners have differing views on the
adequacy of the 2006 guidance, which may affect how consistently the
guidance is applied.
Federal Banking Regulators Addressed CRE Issues before and after the
Financial Crisis by Issuing Guidance on CRE Concentrations and Loan
Workouts:
The regulators began to address CRE concerns before the financial
crisis. Beginning in the early 2000s, the agencies reviewed CRE
concentrations and risk-management systems across banks. For example,
an OCC review found potential for improvement in banks' risk-
management processes for CRE concentrations, including the sufficiency
of stress testing. The regulators issued draft guidance in January
2006 on CRE concentrations and risk management, based in part on the
trends they had observed in CRE concentrations and risks.[Footnote 28]
The draft guidance elicited considerable feedback from bank
representatives, many of whom stated it would curtail their CRE
lending, impose arbitrary limits on CRE concentrations, and require
additional capital without explicitly stating how much would be
required. The regulators revised the guidance based on the feedback
received. Issued in final form in December 2006, the interagency
guidance provides levels of CRE concentrations that will result in
additional regulatory attention on risk-management systems: (1) 300
percent of CRE loans to total capital, (2) increases of 50 percent or
more in CRE loans during the prior 36 months, and (3) 100 percent of
CLD (or ADC) loans to total capital. In determining the concentration
ratio, owner-occupied CRE is removed.[Footnote 29] The guidance also
states that the concentration numbers are not limits, but rather
indicate when banks will receive closer scrutiny of risk-management
systems and capital adequacy. Such thresholds are not intended to be a
"safe harbor"--that is, banks with lower concentrations may still
receive scrutiny of their CRE loans in examinations--and banks that
exhibit other risk factors can receive criticisms on their CRE
concentrations.[Footnote 30]
In October 2009, after the start of the financial crisis and the
widespread deterioration in CRE loan performance, regulators issued
interagency guidance on CRE loan workouts.[Footnote 31] According to
the regulators, the guidance was issued to (1) help ensure consistent
CRE loan and workout treatment among the regulators, (2) update and re-
assert previous guidance, (3) inform banks of examiner expectations,
and (4) ensure that supervisory practices do not inadvertently curtail
the availability of credit to sound borrowers. Officials told us that
the guidance was not intended as forbearance, but to encourage prudent
loan workouts. While the 2009 guidance was similar to that issued in
1991 and 1993, regulatory officials noted that it includes updates for
changes in accounting (for example, related to ALLL), information on
risk management for CRE loan workouts, and numerous examples to assist
banks and examiners in interpreting the guidance. The examples provide
scenarios for different CRE loan classification outcomes and whether
loans should be considered troubled debt restructurings (TDR), among
other issues.[Footnote 32] Bankers with whom we spoke stated that the
examples were helpful in understanding how to apply the guidance.
Examiners told us that the examples have helped to resolve differences
of opinion with bankers on how to treat certain CRE-related loans. In
addition to the 2009 CRE loan workout guidance, the regulators issued
statements on lending to creditworthy borrowers and creditworthy small
business borrowers to encourage prudent lending among banks and
balanced supervision among examiners.
Regulators Rely on a Variety of Processes to Help Ensure Examinations
of CRE Portfolios Are Consistent and Appropriate, and Some Processes
Have Identified Inconsistencies:
Federal banking regulators help ensure consistency among examinations,
and appropriate application of guidance, primarily through the ROE
review process--but also through training, internal reviews, quality
assurance processes, and processes for obtaining input from banks.
Such processes reflect federal internal control standards, which
provide reasonable assurance that management directives are carried
out. The federal government standards for internal control state that
managers should have controls in place to compare actual performance
to planned or expected results over time throughout the organization
and analyze significant differences.[Footnote 33] All of the
regulators' processes were used in some form to implement CRE guidance
and ensure consistent treatment of CRE loans. Some of the internal
review processes have identified inconsistencies in the application of
CRE guidance.
ROE Review Process:
The regulators' examination drafting and review process is iterative,
with multiple levels of internal review. According to regulatory
staff, this design helps ensure consistent application of guidance and
treatment of banks. Figure 5 illustrates the examination process of
the federal banking regulators. The process and the staff involved
vary slightly for each regulator and based on a bank's CAMELS rating.
Figure 5: The Community Bank Examination Review Process at FDIC, the
Federal Reserve, and OCC:
[Refer to PDF for image: illustrated table]
Conducts bank safety and soundness examination, including reviewing
loans and compliance with laws and regulatory guidance:
FDIC examination team;
Participates in the examination and assembles the draft ROE for
further review based on the findings of the examination team:
EIC;
Reviews the draft ROE, answers questions from, or poses questions to
the EIC related to the examination:
Case manager/field supervisor/supervisory examiner;
Reviews the draft ROE for support of findings and consistency:
Case manager/field supervisor/supervisory examiner;
Management review and signature[A]:
Field Supervisor/Supervisory Examiner (1)(2);
Headquarters involvement: None;
Management review and signature[A]:
Assistant Regional Director (3); Deputy Regional Director/Regional
Director (4)(5);
Headquarters involvement: Risk Management and Applications Section
conducts a post-examination review after receiving the ROE and the
Problem Bank Memorandum (for banks rated 4 and 5, and certain banks
rated 3).
Conducts bank safety and soundness examination, including reviewing
loans and compliance with laws and regulatory guidance:
OCC examination team;
Participates in the examination and assembles the draft ROE for
further review based on the findings of the examination team:
EIC or portfolio manager;
Reviews the draft ROE, answers questions from, or poses questions to
the EIC related to the examination: [Empty];
Reviews the draft ROE for support of findings and consistency:
Analyst (working closely with an Assistant Deputy Comptroller);
Management review and signature[A]:
Assistant Deputy Comptroller (1)(2);
Headquarters involvement: None;
Management review and signature[A]:
District Supervisory Review Committee: Chaired by the District Deputy
Comptroller and consisting of Assistant Deputy Comptrollers,
attorneys, analysts, and problem bank specialists (3)(4)(5);
Headquarters involvement:
Deputy Comptroller for Special Supervision (for problem banks assigned
to the national office).
Conducts bank safety and soundness examination, including reviewing
loans and compliance with laws and regulatory guidance:
Federal Reserve examination team;
Participates in the examination and assembles the draft ROE for
further review based on the findings of the examination team:
EIC;
Reviews the draft ROE, answers questions from, or poses questions to
the EIC related to the examination:
Team leader;
Reviews the draft ROE for support of findings and consistency:
Case manager/examining manager/examining officer;
Management review and signature[A]:
Assistant Vice-President (1)(2);
Headquarters involvement: None;
Management review and signature[A]:
Assistant Vice-President or Vice President (3);
Headquarters involvement:
Post-examination review at the Federal Reserve Board for some banks
rated 3;
Management review and signature[A]:
Vice President or Senior Vice President (4)(5);
Headquarters involvement:
Review at the Federal Reserve Board.
Source: GAO.
(#) CAMELS composite rating.
[A] Signature authority may vary based on regional delegations of
authority.
[End of figure]
For all examinations, a team of examiners will conduct on-site work,
led by an examiner-in-charge (EIC), who drafts the ROE. Other staff
and management also discuss findings with the examination team and
review the examination report. The case manager in particular helps
ensure consistency. Case managers review draft ROEs for consistency
and adequate support of findings for a portfolio of banks. The analyst
function at OCC serves a similar role: reviewing many ROEs, although
not assigned to a specific portfolio of banks. While case managers and
senior management generally do not review loan classification details,
they review loan classification writeups in ROEs for accuracy and
support for CAMELS ratings in a broad range of ROEs. According to
Federal Reserve officials, case managers and senior management hold
discussions with the examination teams as examination findings are
being finalized, to ensure that they are appropriate. Therefore, these
roles help ensure consistent application of guidance among various
examiners. In certain instances, the regulators' headquarters offices
in Washington, D.C., may participate to help ensure consistent
implementation of policy guidance.
Training:
Regulators also provide training on new guidance to help ensure
consistent application. All the agencies offered multiple training
opportunities or conference calls on the 2006 CRE concentration and
the 2009 CRE loan workout guidance. For the 2009 CRE loan workout
guidance, Federal Reserve and FDIC headquarters staff visited field
offices, and all regulators hosted conference calls with examiners to
better ensure that the field examiners were implementing it as
intended. Some field offices also included these CRE topics in their
own training and team meetings.[Footnote 34]
Internal Audits and Quality Assurance Processes:
Regulators also have internal reviews and quality assurance processes
to help promote consistency, including consistent application of the
CRE guidance. Regulators' internal reviews include comprehensive
audits that recur periodically, and real-time and post-ROE quality
processes.[Footnote 35] Some of these reviews identified
inconsistencies or other needed improvements related to examiner
treatment of CRE loans. For example:
* For certain FDIC regions, reviews found that examiners could have
better documented findings on CRE concentrations or could have
provided earlier or harsher criticism of CRE concentrations, and the
regional office could have better monitored CRE concentrations among
the banks it supervised. According to an FDIC official, the regions
already have addressed some of these findings.[Footnote 36]
* Certain districts of the Federal Reserve System reviewed
implementation of the 2006 CRE concentration guidance and found
instances of inconsistency.[Footnote 37] The reports concluded that
the guidance could have clarified expectations for how examiners
should review banks' compliance with CRE-related risk-management
practices and noted that a common, mandatory process for reviewing
banks' compliance with the 2006 guidance would have resulted in better
documentation and consistency. In particular, these reviews found that
examination workpapers sometimes lacked sufficient documentation to
determine if the examiner adequately assessed compliance with the
guidance, particularly related to CRE portfolio-level stress testing.
According to Federal Reserve officials, Washington staff also
coordinated separate reviews related to implementation of the 2006
guidance, which resulted in internal clarifications of the appraisal
review process, ALLL assessment guidance, examiner training sessions
on the use of interest reserves and TDRs, and contributions to the
2009 loan workout guidance.
* According to a San Francisco Federal Reserve Bank official, the San
Francisco Federal Reserve Bank implemented a "look back" process in
June 2010 in which a senior official reviews the sufficiency of
support for downgraded CRE loans for all issued ROEs--in response to
criticism that examiners were being too harsh and curtailing credit.
Of 11 CRE loan downgrades reviewed in the third and fourth quarter of
2010, this official stated that 2 should not have been
downgraded.[Footnote 38] Specifically, according to this official, the
loans initially were considered collateral dependent, but after closer
review the official determined that the borrowers had some capacity to
repay, so the loans should have been classified but not yet charged
off. In these two cases, the loan downgrades were reviewed and changed
before the ROEs were finalized and were consistent with the bank's
internal loan ratings. According to this official, the findings from
this quality process will be used to improve the accuracy of CRE loan
classification.
* Similarly, all OCC districts instituted a real-time review process
in which experienced staff reviewed the accuracy of CRE loan
classifications--before the ROE is finalized.[Footnote 39] For
example, OCC's central district in January 2009 reported that 95
percent of examiners' ratings decisions on CRE loans, and 99 percent
of their accrual decisions, were determined to be accurate. Among
those classifications that were corrected, 3 percent were downgraded
and 2 percent were upgraded. Based on these findings, the district
concluded that the vast majority of examiner loan classifications were
accurate but recommended more training to address the discrepancies.
The western district's quality assurance process concluded that 4
percent of risk ratings were incorrect.[Footnote 40]
Processes for Obtaining Bank Feedback:
Regulators also use surveys to gather information on how to improve
the examination process and understand the impact of policies on the
banking industry.[Footnote 41] For example, the regulators issued an
interagency survey for examinations conducted between May 31 and July
9, 2010. According to an FDIC analysis of the resulting data, more
than 97 percent of respondents stated that the 2009 CRE loan workout
guidance has been helpful. In addition, nearly 88 percent of banks
stated that no specific guidance was inhibiting them from working with
troubled borrowers. Among the remaining 12 percent, just over three-
quarters of them raised concerns about accounting-related guidance and
reporting of TDRs. Based on this information, regulatory officials
from FDIC, the Federal Reserve, and OCC believe that the 2009 CRE loan
workout guidance has been helpful.
Comments provided to regulatory officials during the examination
process and through the formal appeals process provide information
about banks' concerns on ratings and whether regulatory guidance has
been applied consistently. According to bank and regulatory officials
with whom we spoke, when bank officials have raised concerns, they
tend to first approach the examination team. Bank officials also can
contact the ombudsman offices at the regulators to seek confidential
assistance.[Footnote 42] In addition to these avenues, banks formally
can appeal regulatory decisions. Although bankers have multiple
options for raising concerns about regulatory actions, our interviews
with bank officials found that some were cautious about raising issues
because of potential repercussions from regulatory officials.[Footnote
43] In contrast, other bank officials stated that they do contact
regulatory officials when warranted, although a few raised concerns
about the time and expense of pursuing formal appeals. Regulatory
officials told us that many bank officials regularly reach out to
them, and a few officials also noted that they provide information to
bank officials about the ombudsman and the appeals process--should
banks want to raise concerns.[Footnote 44]
Banks' Concerns about Examiner Treatment of CRE Loans Highlight
Challenges in Addressing CRE Downturn:
Interviews with officials from 43 banks in different parts of the
country identified multiple concerns with examiner treatment of CRE
loans and related issues.[Footnote 45] Many bank officials'
overarching concern was that examiners have been applying guidance
more stringently than before the financial crisis--a shift that a few
bankers commented was a difficult adjustment.
Loan Classifications and Effect on Earnings:
Some bank officials we interviewed expressed concerns with examiner-
required loan classifications. From the perspective of a few bank
officials we interviewed, a loan is performing when the borrower
continues to pay and should not be classified. However, according to
regulatory guidance and statements of regulatory officials, such a
loan may be classified if identified weaknesses suggest a reduction in
the borrower's capacity to repay that in turn could lead to future
nonpayment. According to bankers and examiners with whom we spoke,
"global cash flow" analysis always has been part of reviewing loans,
but in the current economic downturn examiners have been focusing more
closely on analysis and documentation of borrowers' and guarantors'
global cash flows. The purpose of such analysis is to determine
whether they have sufficient income and liquid assets to support loan
payments. In some cases, such analysis shows that a borrower is unable
to pay the loan, even if the borrower is currently paying. For
example, the borrower's income and other debt obligations, when
reviewed as a whole, could show that the borrower's debt obligations
exceed income, which raises questions about whether the borrower will
continue paying on the loan in the future.
The renewed focus on global cash flow analysis, in part, led many bank
officials to conclude that examiners were classifying loans based
either on collateral value or because the bank lacked updated
financial statements. Regulatory field staff acknowledged that global
cash flow analysis can be difficult to conduct because borrowers
sometimes do not provide banks with updated financial statements.
However, regulatory officials told us that examiners do not classify
loans solely because of a lack of financial statements, but a lack of
such statements combined with other weaknesses could provide
sufficient support for classifying a loan. If the borrower lacks the
ability to repay, the loan then could be considered "collateral
dependent." Such loans are classified based on the value of the
property, and tend to rely on values established in appraisals.
According to some bank officials we interviewed, examiners have been
more critical of recent appraisals. For example, these officials
stated that examiners have been requiring appraisals on CRE collateral
more often, criticizing the banks' appraisal review process, and
criticizing the appraisals themselves.
Classifications are a major concern for banks primarily because they
can result in reduced earnings. For example, an examiner may determine
that a bank should place a classified loan on nonaccrual--which means
the bank cannot accrue the interest income as earnings. While some
bankers put loans on nonaccrual themselves, a few bank officials with
whom we spoke stated that examiners have been asking bankers to place
more loans on nonaccrual. Classifications also can reduce earnings
because they factor into ALLL, which a bank estimates based on
accounting guidance from the Financial Accounting Standards Board
(FASB).[Footnote 46] As more loans are classified, more is generally
reserved in ALLL to anticipate future losses from nonperforming loans.
[Footnote 47] In our interviews with bank officials, some stated that
examiners have been requiring additional ALLL and criticizing the ALLL
methodology. In addition, a few bankers noted that some examiners want
ALLL increased based on their peers' ALLL rather than the bank's
individual situation.
Application of CRE-related Guidance:
Many bank officials with whom we spoke were concerned that examiners
have been misapplying the 2006 guidance. As we discuss above, the 2006
guidance states that the CRE and ADC concentration levels are not
limits, but some bank officials told us that examiners have been
interpreting them that way. A few bank officials also stated that
examiners have not been calculating CRE concentrations according to
the 2006 guidance: some examiners were including owner-occupied CRE
and some were using the wrong type of capital for the calculation,
which inflated the concentration levels (we also found this in our
analysis, described in more detail below).[Footnote 48] A few bankers
stated that examiners told them they exceeded the 300 percent
concentration threshold for CRE, based on these faulty calculations,
but according to the calculations in the guidance they actually were
under the threshold. Furthermore, a few bank officials also stated
that it was unclear to them what examiners expect in complying with
requirements related to CRE and risk management--for example, on what
is considered to be satisfactory stress testing.
While more bank officials than not noted that examiners' actions have
been consistent with the letter of the 2009 CRE loan workout guidance,
a few stated that examiners were not always complying with its spirit:
to allow the banks time to work with borrowers until the current CRE
downturn passes. Two bankers with whom we spoke stated that it was
their experience that examiners were particularly stringent in 2008
when the financial crisis was escalating, but moderated their approach
in late 2009, which is around the time that the 2009 CRE loan workout
guidance was issued. An internal review by OCC's Midsize and Community
Banks Division came to a similar conclusion and noted that examiners
have become more consistent in their CRE loan treatment through
internal discussions, training, and policy communication efforts. A
few bank officials with whom we spoke provided specific suggestions on
how to improve policy guidance--such as clarifying what amount of debt
service coverage is acceptable in a loan workout, how best to conduct
global cash flow analysis, and when new appraisals are needed--but a
few others felt that some form of general regulatory reprieve was
needed for community banks to work through the downturn.
CAMELS and Capital Requirements:
Bank officials we interviewed also stated that their experience with
increased supervisory scrutiny was being reflected in CAMELS ratings
and additional capital requirements. For example, many bank officials
thought the management component rating was more critically assessed
now, and heavily driven by asset quality and other component ratings.
A few bank officials added that they were being rated on deterioration
in their portfolios that was due to the broader economic downturn and
problems in their geographic market that were out of their control.
Some bank officials with whom we spoke stated that examiners have been
more aggressive about requiring additional capital--and two bank
officials in particular stated they thought this was especially the
case for banks with high CRE concentrations.
However, a few bankers thought the additional scrutiny was
appropriate, but should not necessarily be focused on all banks. For
example, one banker stated that if examiners had been applying the
guidance stringently before the crisis that perhaps the banks could
have avoided some of the current problems. A few others also noted
that stricter scrutiny was appropriate given the current CRE market
situation and the severity of the economic downturn. Additionally, a
few bank officials stated that the regulators should focus on the
community banks that caused the problems, rather than subjecting all
community banks to such strict scrutiny.
Regulators Have Incorporated Lessons Learned from the Financial Crisis
into Supervision, Which May Explain Some Bank Officials' Experiences
of Increased Scrutiny:
Regulators have been incorporating into their regulatory processes a
number of lessons learned from the financial crisis, including
findings from the agencies' IGs. Specifically, the IGs of the banking
regulators completed 106 MLRs in 2009 and 2010 for banks that failed
during the recent financial crisis.[Footnote 49] As noted in a
December 2010 report by the FDIC IG that summarizes certain MLR
findings, FDIC determined based on the MLRs that earlier supervisory
action was needed to address banks with high risk profiles or weak
risk-management practices. We also found in past work that regulators
identified a number of weaknesses in institutions' risk-management
systems before the financial crisis began but did not always take
forceful actions to address them.[Footnote 50] In addition, the
Financial Crisis Inquiry Commission report notes areas in which
regulators could have been more proactive in using regulatory tools to
address certain risks in the financial system.[Footnote 51] A number
of nonmanagement regulatory staff in the field offices we visited
acknowledged they could have better followed up on outstanding issues.
In response to lessons learned, regulatory officials stated that they
have been following up more often on matters requiring attention (MRA)
and refocusing their supervisory efforts. For example, OCC's Midsize
and Community Banks Division issued an MRA Reference Guide that
provides examiners with OCC policy guidance on how to report, follow
up on, and keep records related to MRAs. FDIC in June 2009 also
implemented its "Forward Looking Supervision" program that re-
emphasizes reviewing all aspects of a bank's risks during the
examination process. The program focuses on helping ensure that (1)
CAMELS ratings reflect consideration of bank management practices
without relying solely on a bank's financial condition; (2) examiners
review risks associated with concentrations and wholesale funding
sources; (3) appropriate capital is maintained; and (4) examiners
follow up on progress related to MRAs and enforcement actions.
Although Most Examinations We Reviewed Followed CRE Guidance, a Few
Illustrated How Treatment of CRE Concentrations May Be Inconsistent:
Based on our analysis of a nonprobability sample of 55 ROEs,
examiners' findings were generally consistent with policy guidance,
with some exceptions. Examiners made statements in ROEs related to the
quality of banks' loan workouts that were consistent with the 2009
guidance on CRE loan workouts.[Footnote 52] ROEs in our sample that
comment broadly on banks' CRE loan workouts tend to cite areas for
improvement (20 of 27). Examiner concerns include that the bank
management or its board could have better identified, monitored, or
tracked problem loan workouts, and therefore better identified loans
that should have been reported as TDRs. Improvements to managing loan
workouts that examiners cited include (1) reporting on current loan
status and related developments (such as periodic analysis of the
borrower's financial situation); (2) creating and tracking benchmarks
to measure workout progress; (3) providing the rationale for loan
grades related to loan workouts; and (4) updating collateral values
(as appropriate). Almost half of the ROEs in our sample that raise
concerns related to CRE loan workouts (8 of 20) specifically note
concerns about the nature of banks' loan workouts. For example, in
these cases, examiners most often stated that loans were restructured
and extended on unsustainable terms that either resulted in further
asset quality deterioration, did not adequately assess the borrower's
ability to repay, or did not follow the 2009 CRE loan workout guidance.
In our sample, most ROEs (44 of 55 sampled) raise concerns about CRE
concentrations and how they are managed. In more than half of those
(24 of 44), the concerns are supported by risk-management deficiencies
and explicitly cite the 2006 CRE concentration guidance. Specifically,
the findings include concerns on the bank's (1) need to update or
enhance internal policies on CRE concentration limits and CRE
underwriting acceptable to the bank; (2) monitoring of CRE
concentrations; (3) management information systems used to track and
report various types of CRE; (4) ability to inform the bank's board of
directors about trends in CRE concentrations; and (5) the adequacy of
stress testing of CRE loans.
However, in 7 instances (of 44), the ROE includes statements that the
bank must reduce its CRE concentrations, but the basis for this
requirement was unclear or appeared inconsistent with the 2006 CRE
concentration guidance.[Footnote 53] For example:
* One ROE states that the bank needed to match its own internal policy
on CRE concentrations to those in the 2006 guidance, and referred to
the concentrations in the guidance as "limits." Referring to the
thresholds in the 2006 guidance as limits is inconsistent with that
guidance.
* In two other instances the ROEs state that the bank must reduce its
CRE concentrations--citing them as "excessive" for example--but do not
focus on the bank's risk-management systems. However, the enforcement
actions for these banks did not require reduced CRE concentrations and
emphasized improvements to risk management. One of these ROEs states
repeatedly that the bank must reduce its CRE concentrations because
the concentrations were too high "in the view of" the regulator. The
related enforcement action did not require reduced CRE concentrations
explicitly but required that the board "refine the concentration risk-
management system" in part by establishing its own limits for certain
CRE concentrations and adhering to them.[Footnote 54] Differences in
message between an ROE and an enforcement action could be confusing to
bank boards and management as they seek to comply with regulatory
requirements for risk management related to CRE concentrations.
Moreover, such confusion could lead bank officials to misunderstand
whether they should focus on improving their risk-management systems
or just reduce their total CRE concentration numbers.
* Another ROE acknowledges that the bank was below the CRE threshold
indicated in the 2006 guidance but states the bank nonetheless should
follow the guidance and assesses in detail the bank's compliance with
it. If banks are closely assessed on their compliance with the 2006
CRE guidance, although they have not reached the CRE and ADC
thresholds,
* bank officials could be unclear on what the trigger is for
compliance with CRE risk-management requirements.
* One case in particular provided ambiguous information to the bank
about whether it had the appropriate risk-management systems in place
to manage its CRE concentrations. The ROE requires a bank with a CRE
concentration of about 600 percent of tier 1 capital to address a
matter requiring immediate attention to improve stress testing for its
CRE portfolio. The ROE also states that the bank needed to reduce its
CRE concentrations. However, the ROE states that the bank was in
compliance with the 2006 CRE guidance--which requires robust stress
testing for CRE portfolios when banks reach certain levels of CRE.
Requiring a bank to address a matter requiring immediate attention
related to CRE risk management and noting that the bank must reduce
its CRE concentrations--while also stating that it is complying with
the 2006 guidance--could send an unclear message to bank officials
about why they need to reduce CRE concentrations if overall they are
complying with the guidance.
Additionally, we found that out of 47 ROEs that include CRE
concentration information, a number of them did not include CRE
concentration numbers that were calculated according to the 2006 CRE
guidance. For example, some ROEs appear to include owner-occupied CRE
as part of the CRE concentration calculation (14 of 47), although the
2006 CRE guidance specifically excludes this type of CRE. We also
found that 23 of these 47 ROEs include CRE concentrations calculated
by using some combination of tier 1 capital (and sometimes also
include a number simply referred to as a "concentration," although how
it was calculated was unclear). However, another 24 ROEs specify using
either total risk-based capital or equity capital (or also include
tier 1 capital), which is consistent with the 2006 guidance.[Footnote
55] The effect of calculating these concentrations differently can be
to increase the total CRE concentration number, which increases the
scrutiny placed on the banks' risk-management systems. Sometimes the
difference can be large: one ROE in our sample that includes both
calculations shows a total CRE concentration of 432 percent when using
tier 1 capital and 341 percent when using total risk-based capital.
However, the difference also can be smaller: one ROE in our sample has
a concentration calculated with tier 1 capital at 141 percent; with
total risk-based capital it was 133 percent. While FDIC clarified to
its examiners in April 2010 how to calculate CRE concentrations, other
regulators have not done so. Moreover, two of the FDIC ROEs in our
sample that use only tier 1 capital in the calculation were issued
after the April 2010 clarification.
Regulatory Officials' Differing Views on the Adequacy of the 2006 CRE
Concentration Guidance Could Lead to Inconsistent Treatment of CRE
Loans:
Senior officials and field examiners have differing views on whether
the 2006 CRE guidance is sufficient in addressing CRE concentration
risks. We interviewed about 200 field staff associated with the bank
examination review process at FDIC, the Federal Reserve, and OCC in
Atlanta, Boston, Dallas, and San Francisco.[Footnote 56] A number of
field examiners from all the agencies stated they did not have the
tools to proactively address growing CRE concentrations when the
economy was strong or that some banks ignored examiners' concerns on
CRE risk management. A number of examiners also admitted that during
strong economic times they could have been more assertive in asking
banks to implement risk-management changes related to CRE
concentrations. When asked whether limits on CRE concentrations should
be considered or whether specific amounts of capital should be
required at certain concentration levels, some examiners did not think
that limits were the answer, but others thought that there might be
some level of concentration that was too high even when managed well,
because a market downturn would expose banks to significant losses. In
addition, some thought that a focus on additional capital would be
sensible given the severe capital shortfalls some banks with CRE
concentrations faced during the financial crisis.
Senior regulatory officials with whom we spoke had differing views on
whether the 2006 guidance was sufficient for examiners to address the
buildup in CRE concentration risks. FDIC senior officials stated that
the current guidance was sufficient for examiners to address risks
related to CRE concentrations and did not think changes were needed.
In contrast, OCC has been reviewing whether particular capital
requirements should be set for banks that have higher CRE
concentrations and stated that this could lead to changes in OCC or
interagency guidance. At the Federal Reserve, senior officials
believed that the existing 2006 guidance was largely sufficient, but
noted that efforts to clarify expectations for stress testing and
capital planning were ongoing. The examiners and senior officials with
whom we spoke agreed that determining certain limits on CRE
concentrations, or requiring specific amounts of additional capital
for certain levels of CRE concentrations, would be difficult and
require significant study. Federal Reserve officials also noted that
limits or specific capital requirements would require studies on the
potential effect on credit availability. Examiners exercise
significant judgment during examinations, and different perceptions
about the 2006 guidance among regulators could send mixed signals to
examiners--which could affect how they apply the guidance. In
addition, as noted earlier, the regulators' processes to review and
monitor application of examiner guidance and our review of ROEs
identified some inconsistencies. Monitoring and revising existing
controls, such as guidance, is a key component of a strong internal
control system and reflects management's efforts to implement findings
from quality control processes.
Multiple Factors Can Affect Banks' Lending Decisions, Including
Regulators' Actions:
Capital Requirements Can Affect Lending:
Regulators require banks to maintain certain minimum capital
requirements to help ensure the safety and soundness of the banking
system. However, increases in capital requirements can raise the cost
of providing loans, which would lead to higher interest rates for
borrowers, tighter credit terms, or reduced lending. While capital
provides an important cushion against losses for banks, there is a
trade-off between building up this cushion to provide greater
protection against unexpected losses and increasing lending and
returns to shareholders. Holding more capital against each loan means
less equity is available to return to shareholders or back new
loans.[Footnote 57]
Empirical literature generally supports this basic understanding of
the impact of bank capital requirements on lending. For example,
researchers found in one study that bank capital requirements
substantially affected bank loan growth during the last economic
downturn. Specifically, in evaluating bank regulatory agreements in
New England, researchers found that capital requirements significantly
affected the lending behavior of banks. They noted that those banks
with "low or no profits and an inability to obtain new capital at
reasonable rates" decreased their assets and liabilities to meet the
higher capital-to-asset ratios required by regulatory enforcement
actions.[Footnote 58] Using the "capital crunch hypothesis," the
researchers found that institutions with lower capital ratios had
slower loan growth (or loans shrank more rapidly) to try to satisfy
capital requirements.[Footnote 59]
High Concentrations in CRE Can Inhibit Banks' Ability to Lend,
Especially during a Credit Downturn:
Banks with capital bases that have been negatively affected by losses
in their CRE portfolios--or those trying to improve their capital
ratios or ALLL to guard against potential losses--may need to reduce
lending to maintain an adequate capital-to-assets ratio on their
balance sheets. Although limited research exists on the impact of CRE
loan concentrations on a bank's ability to lend, an existing study
shows that high CRE concentrations can limit loan growth during
economic downturns. For example, this study found that banks with high
CRE concentrations before the recent financial crisis made loans to
other sectors of the economy during this crisis at a "significantly
slower rate" than banks that did not have high CRE exposure.[Footnote
60] In addition, the researchers found that the higher the bank's CRE
concentration prior to the crisis, the more its non-CRE lending slowed
during the crisis. The reasons for the contraction of non-CRE lending
during the crisis are being examined. The authors hypothesize that the
rise in CRE lending and the substantially increased delinquencies on
these loans "could have inhibited banks' willingness or ability to
lend to other segments of the economy--particularly when banks' demand
for liquidity and capital was high." The authors also cite the
possibility that high-CRE banks may have failed at a greater rate than
banks without that level of CRE exposure.
Limited Research from Past Downturns on the Effect of Examiner Actions
on Lending Suggests It Is Minimal:
Our assessment of existing studies and interviews with bank officials
found that market factors tend to drive CRE downturns and suggests
that the regulatory effect of examiner actions on such downturns--as
evidenced in studies of the downturn of the 1990s--was minimal.
Bankers we interviewed attributed the CRE downturn to market factors
such as problems in residential real estate that affected the CRE
market and the severity of the broader financial and economic crisis.
Although bankers did not state that regulatory policies were the cause
of the CRE downturn, many noted that examiner actions were
exacerbating it and a few stated banks needed to be given time to work
through their troubled assets so they could continue to lend and
support the economy. Other bankers stated that examiners have been
impeding banks' ability to make new loans--especially if the bank
already had high CRE concentrations. That said, a few bankers noted
that CRE loan demand from creditworthy borrowers was down
significantly, and this was inhibiting loan growth.
There is limited research on the effect of examiner actions on credit
cycles; however, the studies that exist suggest the effects are
minimal. Specifically:
* In an analysis of the credit crunch from 1989 to 1992, researchers
found modest support for the hypothesis that increased regulatory
"toughness" occurred and that this affected bank lending. In a
comprehensive study spanning the last financial crisis, three
hypotheses were tested regarding changes in regulatory toughness and
its impact on bank lending.[Footnote 61] The data provided what the
authors call modest support for all three hypotheses that: (1)
toughness increased during the credit crunch from 1989 through 1992,
(2) it declined during the boom from 1993 through 1998, and (3)
differences in toughness affected bank lending. During the credit
crunch they studied, the data show no more than 1 percent additional
loans receiving classification or worsening of classification status.
During the boom, the data show a similar change for a decrease in loan
classifications. The authors also reviewed the economic significance
of changes in regulatory "toughness" and found that growth in the
number of classified assets by 1 percent would be predicted to
decrease the ratio of real estate loans to gross total assets by less
than 1 percentage point over the long term, and frequently this impact
was projected to be significantly less than 1 percentage point.
Changes in CAMEL ratings were not found to have a "consistent" impact
on future lending behavior, and when there was an impact, the data
show that it was minimal.[Footnote 62]
* Another article specifically focuses on how changes in CAMEL ratings
affected loan growth from the period that spanned 1985-2004.[Footnote
63] During the 1985-1993 credit crunch, the authors found some
evidence that changes in CAMEL ratings, both the composite and the
components, had a significant impact on loan growth for commercial and
industrial loans but a smaller effect on consumer loans and real
estate loans.[Footnote 64] However, the authors found minimal evidence
that adjustments in CAMEL ratings, including both composite and
component ratings, had any systematic effect on loan growth during
what they define as an economic recovery period (1994-2004). The
researchers also noted that, based on their research, banks may
respond "asymmetrically" to changes in CAMEL ratings. Specifically,
banks may decrease loan growth when their CAMEL ratings are
downgraded, but they do not necessarily increase it when their CAMEL
ratings are upgraded.
* These studies suggest examiners' actions can affect lending, albeit
minimally. However, the research suggests that regulators were more
stringent during the past credit crunch, even holding financial
conditions constant. Therefore, regulators should be aware of how
their actions can affect broader credit markets, and help ensure that
their actions do not contribute to unnecessary procyclical effects:
that is, magnification of economic or financial fluctuations.
Regulators Are Aware of the Need to Moderate the Potential Procyclical
Effects of Regulation:
In the aftermath of the recent financial crisis, regulators in the
United States and abroad have been attempting to address the
procyclical effects of their actions. The procyclical effects of
regulation may not adequately discourage overly risky behavior during
economic upswings or may inhibit bank lending during downturns, as
banks may need to meet more stringent requirements during times when
it is more difficult to do so. For instance, if regulators increase
capital requirements at the same time that losses from an economic
downturn decrease banks' capital, banks may be less able to lend while
they seek to rapidly raise additional capital. This can exacerbate
downswings in credit cycles.
Consistent and balanced application of policy guidance in strong and
weak economic times is important to avoiding unnecessary procyclical
effects. Regulatory efforts to better ensure that guidance is applied
consistently during strong and weak economic periods helps to ensure
that regulatory policies do not exacerbate economic upturns or
downturns.[Footnote 65] While bankers with whom we spoke understood
why examiners were looking more closely at CRE loans given the
market's downturn, a few said the shift to closer review and attention
was a difficult adjustment. Bank examiners with whom we spoke in the
field offices also noted that problems can be difficult to identify
during strong economic times.
Discussions about the procyclicality of regulation have been a central
feature of recent deliberations on revised capital requirements among
U.S. banking regulators and the Basel Committee for Banking
Supervision. The discussions have been seeking to address the
procyclical effects of capital requirements by having banks raise
additional capital, commensurate with risks, during times of economic
growth. In December 2010, the Basel Committee released the framework
for Basel III, which includes increased and higher-quality capital
requirements, enhanced risk coverage, the establishment of a leverage
ratio as a "backstop" to the risk-based requirement, steps to
encourage the "build up" of capital that can be used to absorb losses
during "periods of stress," and the introduction of two global
liquidity standards. As part of the establishment of procedures to
help ensure the consistent global application of this framework, the
Basel Committee has developed standards that will be implemented
gradually so that banks make the shift to higher capital and liquidity
standards while "supporting lending to the economy."[Footnote 66]
Federal bank regulators also have acknowledged the importance of
addressing procyclicality in regulatory requirements and have made
efforts in this regard. For example, the Chairman of the Federal
Reserve has stated the importance of regulators acknowledging the
significance of procyclicality and he has noted that both the Basel
Committee and the Financial Stability Forum have worked to address
this as it relates to capital requirements. In addition, FASB has
issued accounting guidance aimed at changes to mark-to-market
accounting for assessing asset values in inactive markets. More
recently, in May 2010, FASB released a proposed Accounting Standards
Update, which encompassed proposals on the impairment of financial
assets and suggested implementing a more forward-looking impairment
model.[Footnote 67] Based on exposure draft comments, in January 2011
FASB proposed with the International Accounting Standards Board a
common solution on how to account for the impairment of financial
assets and presented the document for public comment. Efforts such as
these seek to address procyclicality concerns related to capital and
accounting requirements, while the potential procyclical effects of
examiners' application of policy guidance is something regulators
consider in their supervision of banks, according to regulatory
officials with whom we spoke. The recent financial crisis underscored
how important it is for regulators to evenly apply guidance during
strong economic periods, although this was not always the case, as
previously noted. Consistent application of guidance is important to
avoid unduly hampering credit provision throughout the economy.
Conclusions:
CRE still is working through a downturn sparked by the broader
financial crisis, presenting an ongoing challenge to community banks
and regulators. While community banks have been working through the
challenges associated with many years of past growth in CRE
concentrations, CRE portfolios continue to have a significant effect
on community bank balance sheets as loan delinquencies and charge-offs
remain historically high. Community banks continue to seek ways to
work with their borrowers and shore up capital to remain solvent, but
the current economic environment and the expectation that refinancing
of CRE loans will bring a new round of market stress suggest many
community banks may face these challenges for some time. And, because
community banks tend to provide a greater proportion of their loans to
small businesses, the availability of credit to small businesses could
be constrained while community banks work through these difficulties.
Prior to the financial crisis, regulators' efforts included guidance
on CRE concentrations and risk management, but these efforts were not
as robust as they could have been in addressing CRE risks. Since the
financial crisis, the shift in examination focus and differences in
the application of the CRE concentration guidance has contributed to
concerns among community banks about regulatory stringency. That is, a
number of bankers remain concerned that regulators have become more
stringent in reviewing CRE loans since the crisis, which could be
explained partly by regulators re-emphasizing fundamentals and
addressing lessons learned from the crisis. While we and the
regulators have reviewed examiner application of the CRE guidance and
generally found examiners' actions were accurate or well-supported,
some inaccuracies and inconsistencies were evident--particularly
relating to the 2006 guidance. Regulators have mixed views about the
adequacy of the 2006 guidance. Our findings from an analysis of ROEs
were similar to those of the regulators' internal reviews and
assessments, which raised questions about the consistency of policy
guidance application. Given these findings, and in light of lessons
learned from the recent financial crisis and CRE market downturn, the
regulators could reassess the adequacy of the guidance. Revising or
supplementing the guidance to provide more details about risk-
management practices and examples of when to reduce CRE concentrations
would help both examiners and bankers better understand how to assess
and manage such concentrations. Furthermore, incorporating CRE-
specific analyses into the scope of internal and quality assurance
reviews--at least while CRE issues remain a concern--will help ensure
consistent application of the guidance and produce clearly articulated
support in examination reports for requiring reduced concentrations.
In this way, regulatory management can better ensure that examination
practices related to CRE concentrations and risks will be carried out
consistently from examiner to examiner and across regulators.
Consistent treatment also will make clear to banks what regulatory
expectations are for managing CRE concentration risks.
Given the key role community banks play in business lending, bank
regulators are aware of the potential effects of their actions in
exacerbating the credit cycle. Many factors can affect a bank's
decision to lend, including regulatory requirements. But if such
requirements are too stringent, they can unduly limit lending. Such
limits on lending can have widespread effects on the economy, as
acknowledged in Basel Committee for Banking Supervision discussions on
capital requirements. Although isolating the impact of bank
supervision is difficult, the recent severe cycle of credit upswings
followed by the downturn serves as a useful reminder of the
supervisory balance needed to help ensure the safety and soundness of
the banking system and support economic recovery.
Recommendations for Executive Action:
To improve supervision of CRE-related risks, we recommend that the
Chairman of the Federal Deposit Insurance Corporation, the Chairman of
the Board of Governors of the Federal Reserve System, and the
Comptroller of the Currency:
* Enhance and either re-issue or supplement interagency CRE
concentration guidance--based on agreed-upon standards by FDIC, the
Federal Reserve, and OCC--to provide greater clarity and more examples
to help banks comply with CRE concentration and risk-management
requirements and help examiners ensure consistency in their
application of the guidance, especially related to reductions in CRE
concentrations and calculation of CRE concentrations.
* After issuing revised or supplemental CRE concentration guidance,
incorporate steps in existing review and quality assurance processes,
as appropriate, to better ensure that the revised guidance is
implemented consistently and that examiners clearly indicate within
bank examination reports the basis for requiring a bank to reduce CRE
loan concentrations.
Agency Comments and Our Evaluation:
We provided a draft of this report to FDIC, the Federal Reserve, and
OCC for review and comment. All of the agencies provided written
comments that we have reprinted in appendixes III, IV, and V,
respectively. The agencies also provided technical comments, which we
considered and have incorporated as appropriate.
In written comments, the Federal Reserve welcomed our recommendations
to improve CRE concentrations guidance to help banks and examiners
comply with it, and to ensure consistent implementation of such
guidance. The Federal Reserve stated that it intends to work with its
counterparts at the OCC and FDIC to develop and implement enhancements
to CRE concentrations guidance.
In its written comments, the OCC agreed with our conclusions and
recommendations. OCC noted that community banks' increased CRE
concentrations exposes them to CRE market declines, which may require
more explicit regulatory expectations for the robustness of risk-
management systems, stress testing, capital planning, and capital
levels when CRE concentrations increase. OCC also stated that it would
discuss with the other federal banking regulators how to enhance the
2006 CRE concentrations guidance and would ensure the consistent
implementation of any revised or supplemented guidance.
In written comments, FDIC stated that it has already supplemented the
2006 CRE concentrations and risk-management guidance--citing a 2008
Financial Institution Letter, divisionwide training, and internal
reviews. As noted in our report, the federal banking regulators all
have numerous controls to help ensure examination consistency, such as
training and internal reviews that FDIC highlights in its letter.
Nonetheless, our review of ROEs from all three regulators, and their
own internal reviews, uncovered instances of inconsistency in the
treatment of CRE loans and application of the 2006 CRE guidance--
demonstrating that no regulator was immune from consistency issues. We
also noted in our report some concerns raised by bank examiners and
bankers about applying the 2006 guidance, such as whether the current
CRE concentration thresholds are hard limits, how the CRE
concentrations should be calculated, and whether specific amounts of
additional capital should be required for banks with elevated CRE
concentrations. Though FDIC provided clarification on CRE risk
management in March 2008 that could contribute to interagency action
on CRE guidance, this guidance does not address all of the concerns
raised more recently by examiners and bankers that we describe in the
report, nor was it developed in conjunction with the other regulators.
Therefore, we continue to believe that our recommendations on enhanced
or clarified CRE concentration guidance--on an interagency basis that
involves the FDIC--would help bankers and examiners better understand
how to comply with CRE risk management requirements and help ensure
the consistent application of such requirements.
FDIC also cited a study by the Bank for International Settlements that
concluded the social benefits of higher bank capital requirements
outweigh the large reductions in economic activity from a banking
collapse. As our report notes, additional capital provides an
important cushion against losses, though this comes at a cost. From
our review of the literature, there is disagreement on the magnitude
of such costs on lending. We added information to the report to
clarify this issue, which includes information on the study cited by
FDIC.
We are sending copies of this report to FDIC, the Federal Reserve,
OCC, and other interested parties. The report also is available at no
charge on the GAO Web site at [hyperlink, http://www.gao.gov].
If you or your staffs have any questions about this report, please
contact A. Nicole Clowers at (202) 512-8678 or clowersa@gao.gov.
Contact points for our Offices of Congressional Relations and Public
Affairs may be found on the last page of this report. GAO staff who
made major contributions to this report are listed in appendix VI.
Sincerely yours,
Signed by:
A. Nicole Clowers:
Acting Director Financial Markets and Community Investment:
[End of section]
Appendix I: Scope and Methodology:
To assess the condition of the commercial real estate (CRE) market and
the implications for community banks, we collected and analyzed the
following data to provide information on overall trends in CRE:
* To determine trends in CRE prices, we analyzed monthly data from
Moody's/REAL Commercial Property Price Index from January 2002 through
December 2010. We assessed their reliability for the purposes of
providing a picture of the trends in CRE prices by reviewing
documentation on how the data were collected and reviewed for
accuracy. We determined that the data were sufficiently reliable for
the purpose of determining price trends.
* To determine when CRE loans would be up for refinancing and what
percentage of CRE loans were "underwater," we analyzed data on CRE
loan volume by maturity schedule and underlying collateral value
provided by Trepp, a commercial mortgage analysis firm. To determine
the accuracy of these data, we discussed the data with officials and
reviewed documentation on their data quality processes. We determined
that the data was sufficiently reliable for purposes of determining
when CRE loans were maturing and how many were underwater.
To understand how the condition of the CRE market has affected
community banks, we analyzed call report data from the Federal Deposit
Insurance Corporation (FDIC) for banks with assets of less than $1
billion to assess (1) CRE loan concentrations as a percent of total
loans and leases, (2) trends in CRE loan concentrations as a percent
of total risk-based capital, (3) trends in CRE loans that were
noncurrent, and (4) trends in CRE loans charged off. We assessed
changes in the rate of noncurrent CRE loans and CRE loan charge-offs
over time. We also calculated average CRE concentration rates at
community banks from 1996 through 2010 by taking the aggregate
reported total of loans secured by CRE (the sum of construction and
development, nonfarm nonresidential, and multifamily residential real
estate) divided by the reported amount of total risk-based capital. We
conducted similar analyses for commercial banks with assets more than
$1 billion. We assessed the reliability of the call report data by
reviewing the controls in place to help ensure its accuracy and by
relying on past GAO reviews of these data. We determined that they
were sufficiently reliable for the purpose of determining trends in
CRE loan concentrations and performance at community banks.
Reports by the inspectors general of the federal banking regulators
provided additional information on the effect of the CRE market
downturn on community banks. We reviewed all 106 of the material loss
reviews (MLR) issued by the offices of the inspectors general of the
Board of Governors of the Federal Reserve System (Federal Reserve),
FDIC, and U.S. Department of the Treasury (for the Office of the
Comptroller of the Currency, or OCC) from 2009 and 2010. In reviewing
the MLRs, we noted which ones cited concentrations in either overall
CRE or acquisition, development, and construction loans (ADC) as a
factor in the bank's failure. We also interviewed officials at the
Conference of State Bank Regulators on the findings of their
independent review of the MLRs.
Additional reports provided background and information on the overall
condition of CRE markets and their impact on community banks. The
reports we reviewed were culled from research and literature reviews
from academic journals, the Congressional Research Service, the
Congressional Oversight Panel, FDIC, the Federal Reserve, and previous
GAO reports. We also spoke with and reviewed speeches and public
comments from officials at FDIC, the Federal Reserve, and OCC; bank
officials; and academics and a think tank official with expertise on
bank examinations or CRE.
To determine how the banking regulators responded to trends in the CRE
market, we interviewed regulatory and bank officials and reviewed
reports of examination (ROE) from a sample of banks.[Footnote 68] Our
sample selection for bank interviews and reviews of ROEs started with
a data request to FDIC, the Federal Reserve, and OCC on bank
examinations for banks with assets of less than $1 billion with data
elements that included the value of their CRE loans, recent CAMELS
ratings, total risk-based capital, recent enforcement actions, and
other information.[Footnote 69] We determined that the data were
sufficiently reliable for the purposes of selecting a sample, based on
prior use of these data and interviews with agency officials. We
further refined the sample so that we would have a breadth of banks
for interviews and ROE reviews, based on the state in which they were
located, their CAMELS composite rating, and their regulator. We also
wanted to increase the likelihood that banks we sampled were relevant
to our study; therefore, we selected banks with elevated CRE and ADC
concentrations and those that had a recent bank examination. To
achieve these goals, we selected the sample as follows.
* From the bank examination information we received from the
regulators, we selected banks from California, Georgia, Massachusetts,
and Texas. We selected these states because the banks in the first two
states have had a relatively greater share of CRE-related
nonperforming loans, and the latter two states a relatively smaller
share of such loans (as measured by the percentage of CRE loans past
due or in nonaccrual).[Footnote 70] We also wanted to include states
from different regions of the country. To inform the selection, we
conducted an analysis of call report data downloaded from SNL
Financial and held discussions with the federal banking regulators. We
analyzed the following data points for commercial banks with assets of
less than or equal to $1 billion: (1) loans and leases for
construction and land development, multifamily, owner-occupied real
estate, other property, and nonfarm nonresidential; (2) loans 90 days
past due for each of these categories; and (3) loans in nonaccrual
status for each of these categories. We reviewed these commercial
banks in each of the 50 states in relation to these measures and total
assets in CRE loan categories, and arrived at our four states. We
reviewed SNL data reliability and determined that it was sufficient
for the purposes of selecting states for our sample.
* We further refined the sample to include only banks that had an
examination conducted after October 2009, to capture those
examinations for which the 2009 CRE loan workout guidance would have
applied.[Footnote 71]
* From that subset, we placed banks into four "pools," with the goal
of speaking with officials from, and reviewing ROEs for, a breadth of
community banks from a range of states in our sample, from all three
of the banking regulators, and with a range of CAMELS ratings.
- Pool 1 consisted of banks with good CAMELS composite ratings and
high CRE concentrations. In this group, we included banks with a
CAMELS composite rating of 1 or 2 and a CRE concentration above 300
percent of CRE loans (including owner-occupied) to total capital. By
including owner-occupied loans, we would ensure the largest possible
pool of banks and also identify concerns that such banks might have
about regulatory treatment of their CRE loans.
- Pool 2 consisted of banks that generally were in good condition but
also had ADC concentrations. Pool 2 criteria were a CAMELS composite
rating of 2 and both a 300 percent or greater concentration in overall
CRE and a 100 percent or greater concentration in ADC loans to total
capital.
- Pool 3 banks were intended to represent banks that were struggling
and that had a higher number of loans classified as loss at the most
recent examination. These had a CAMELS composite rating of 3, an
overall CRE concentration of 300 percent or greater, and a proportion
of loans classified loss to total assets in the 75th percentile and
above, for banks within our sample. This "loss ratio" was calculated
by taking the total assets classified loss for the most recent
examination and dividing them by total assets.
- Pool 4 was the most distressed pool of banks and consisted of banks
with CAMELS composite ratings of 4 or 5, a 300 percent or greater
concentration in overall CRE in the 75th percentile or greater for the
banks in our sample, and a loss ratio in the 75th percentile of our
sample, calculated as described above.
* Once we selected these pools, we began contacting banks to
interview. We simultaneously began requesting ROEs and some related
workpapers from the federal banking regulators. In that process, we
learned that FDIC and Federal Reserve data included ROEs led by the
state banking regulator (because they share examination
responsibilities with state examiners), and we excluded these from our
sample.
The resulting sample from this process is outlined below, broken down
by regulator (table 5), state (table 6), and CAMELS ratings (table 7).
OCC-supervised banks represent the greatest number of banks in our
sample, in part because a number of the examinations in our sample for
the Federal Reserve and FDIC were led by the state regulator and were
out of the scope of our review. To avoid overweighting the sample with
OCC-supervised banks, we randomly removed some OCC-led bank
examinations for which we had a sufficient number of cases: banks
rated 2 in Texas.
Table 5: Sample Selection by Regulator for ROE Analysis:
Agency: FDIC;
Number: 21;
Percent of total: 38%.
Agency: Federal Reserve;
Number: 12;
Percent of total: 22%.
Agency: OCC;
Number: 22;
Percent of total: 40%.
Agency: Total;
Number: 55;
Percent of total: 100%.
Source: GAO.
[End of table]
Table 6: Sample Selection by State for ROE Analysis:
State: California;
Number: 16;
Percent of total: 29%.
State: Massachusetts;
Number: 5;
Percent of total: 9%.
State: Georgia;
Number: 12;
Percent of total: 22%.
State: Texas;
Number: 22;
Percent of total: 40%.
State: Total;
Number: 55;
Percent of total: 100%.
State: Total for Massachusetts plus Texas (fewer CRE problems);
Number: 27;
Percent of total: 49%.
State: Total for California plus Georgia (more CRE problems);
Number: 28;
Percent of total: 51%.
Source: GAO.
[End of table]
Table 7: Sample Selection by CAMELS Composite Rating for ROE Analysis:
CAMELS composite rating: CAMELS 1;
Number: 4;
Percent of total: 7%.
CAMELS composite rating: CAMELS 2;
Number: 24;
Percent of total: 44%.
CAMELS composite rating: CAMELS 3;
Number: 14;
Percent of total: 25%.
CAMELS composite rating: CAMELS 4;
Number: 3;
Percent of total: 5%.
CAMELS composite rating: CAMELS 5;
Number: 10;
Percent of total: 18%.
CAMELS composite rating: Total;
Number: 55;
Percent of total: 100%.
CAMELS composite rating: Total 1 and 2 rated;
Number: 28;
Percent of total: 51%.
CAMELS composite rating: Total 3 rated;
Number: 14;
Percent of total: 26%.
CAMELS composite rating: Total 4 and 5 rated;
Number: 13;
Percent of total: 24%.
Source: GAO.
[End of table]
To further understand how FDIC, the Federal Reserve, and OCC have
responded to the CRE downturn and its effect on community banks, we
collected and analyzed interagency policy guidance to examiners
related to CRE loan treatment and interagency statements on lending,
and also assessed regulatory efforts to address CRE-related concerns.
As part of this work, we observed examiner training at FFIEC provided
to commissioned examiners, to include a week-long training on CRE and
a day-long training on regulatory updates related to policy guidance
on CRE loans.
To understand banks' concerns about examiners' treatment of their CRE
loans and how examiners supported findings related to CRE loans, we
interviewed bank and regulatory officials and analyzed ROEs.
* We spoke with community bank officials affiliated with 43 community
banks in a number of states (see table 8). Most of the bank officials
with whom we spoke were located in California, Georgia, and Texas
based on our nonprobability sample. We initiated contact with 62 banks
drawn from this sample and interviewed all of the 21 bank officials
who responded to us. We gained additional bank views by supplementing
this sample. Specifically, we interviewed officials from 22 additional
banks that either testified before Congress on the issue of CRE, were
identified to us through bank associations, or had learned of our work
and wanted to talk to us. When we summarize statements from our
interviews with bank officials throughout this report, we use the term
"a few" to refer to 3-10 of 43 banks making the statement; "some" to
refer to 11-25 of 43 banks making the statement; and "many" to refer
to 26-43 banks making a statement. We do not provide specific numbers
in the body of the report to avoid overstating the precision of the
results from the nonprobability sample we used to select bank
interviewees.
Table 8: Locations of Banks Whose Officials We Interviewed:
State: California;
Banks: 12.
State: Florida;
Banks: 4.
State: Georgia;
Banks: 5.
State: Illinois;
Banks: 2.
State: Kansas;
Banks: 1.
State: Massachusetts;
Banks: 1.
State: Maryland;
Banks: 2.
State: Michigan;
Banks: 1.
State: North Carolina;
Banks: 1.
State: New Jersey;
Banks: 1.
State: New Mexico;
Banks: 1.
State: Ohio;
Banks: 1.
State: Oklahoma;
Banks: 1.
State: South Carolina;
Banks: 1.
State: Texas;
Banks: 8.
State: Wisconsin;
Banks: 1.
Source: GAO.
[End of table]
* We interviewed more than 230 regulatory field staff at FDIC,
throughout the Federal Reserve System, and at OCC--along with
additional staff at these regulators' headquarters--to seek views and
information about recent practices on CRE-specific guidance related to
loan workouts and concentrations, training provided on the guidance,
CAMELS ratings, capital requirements, and liquidity issues. The
interviews were conducted at headquarters offices in Washington, D.C.,
and by telephone, video teleconference, and in person at district,
regional, and field offices in California, Colorado, Georgia,
Massachusetts, and Texas. We sought to determine if there were
different views or practices related to CRE loan treatment among
regulatory roles or between those in headquarters and the field
offices, and therefore we interviewed staff in a range of roles and
locations. The staff with whom we spoke in field locations included
field examiners, their supervisors, case managers, analysts (at OCC),
and senior management. Examiners were interviewed both in group
settings and individually, and included those who served as examiners-
in-charge (EIC) for ROEs in our sample. Examiners interviewed in group
settings were gathered by the field offices, and based on our request,
had a range of experience (either less than 5 years or more than 5
years, because examiners are usually commissioned within 5 years).
Individual meetings with EICs were held based on our nonprobability
sample. Of the field staff we interviewed, about 200 were directly
involved in drafting or reviewing ROEs, and about 50 of the 200 were
in senior management positions.
* We analyzed 55 ROEs based on our nonprobability sample, as described
above, of banks in California, Georgia, Massachusetts, and Texas. We
reviewed how examiners supported statements related to banks' CRE loan
workouts, concerns about CRE concentrations, and how examiners
calculated CRE concentrations.
To understand the controls the regulators have in place to help ensure
consistent application of policy guidance, we reviewed the examination
report review process at all of the regulators based on regulatory
guidance and interviews with regulatory officials. We also collected,
compared, and analyzed examination review reports and quality
assurance processes for the three regulators to determine what
processes were in place to identify and address inconsistencies among
examiners, and what findings had resulted from these reviews. For
FDIC, we reviewed reports conducted by FDIC's Internal Control and
Review Section for the Atlanta, Dallas, New York, and San Francisco
regions, because these regions covered the states in our
nonprobability sample. For OCC, we reviewed reports from all four of
its districts related to the agency's quality assurance process that
focused on reviewing the classifications of CRE loans. For the Federal
Reserve, we reviewed a special engagement report from the General
Auditor at the Federal Reserve Bank of Atlanta and a Quality Assurance
memorandum for the Atlanta, Kansas City, Philadelphia, and Richmond
districts. We also discussed with Federal Reserve staff whether other
similar studies existed.
To determine and assess the factors that can affect banks' lending
decisions and their impact, we reviewed and summarized academic
studies that included analysis of various factors on bank lending.
With assistance from a research librarian, we conducted searches of
research databases and report sources (Congressional Research Service,
Congressional Budget Office, JSTOR, ProQuest, EconLit, Accounting and
Tax Database, and Social Science Search). We also sought and reviewed
studies cited by the American Bankers Association (ABA) and the
Independent Community Bankers of America (ICBA). All studies included
published papers released between 1991 and 2010. Based on our
selection criteria, we determined that six studies were sufficient for
our purposes. Specifically, with the assistance of a senior economist,
we analyzed the methodologies underlying these studies and determined
that they were the most relevant to our study and also had robust
controls. Nonetheless, the research conducted in this area is not
exhaustive and focuses primarily on what occurred during the previous
economic downturn of the late 1980s and early 1990s. However, we did
identify one study that examines the role of CRE and its effect on
bank lending in the current financial crisis. To further demonstrate
how loan losses, allowance for loan and lease losses, and capital
requirements can affect lending, we developed an illustrative example
of how loan losses affect capital ratios on a bank's balance sheet,
with assistance from certified public accountants. To obtain
information on how examiner practices may affect lending, we
interviewed bankers, examiners, and regulatory officials. We also
interviewed officials from ABA, the Conference of State Bank
Supervisors, and ICBA.
[End of section]
Appendix II: ALLL and Loan Loss Impact on Capital:
Increases in capital requirements or the allowance for loan and lease
loss (ALLL) can affect a bank's ability to lend. Figure 6 illustrates
relationships between loan losses, bank balance sheets, and capital
requirements under certain assumptions. In this simplified example,
the bank begins with $1,000 in assets ($1,010 in loans and $10 in
ALLL), $900 in liabilities, and $100 in capital, which equates to a
total capital ratio of 10 percent (calculated by dividing total
capital by total assets).[Footnote 72] In this example the bank has
analyzed the collectibility of its loans and decided to add $20 to its
ALLL in anticipation of loan losses. Provisions for these losses
increase the ALLL, which in turn are charged to the bank's expenses,
reduce income, and therefore reduce retained earnings that are
included as part of total capital. As a result, the capital ratio
falls to 8.2 percent. If the bank identifies as uncollectible and
charges off a $20 loan that it holds as an asset, given the
assumptions in the example, the bank's total loans and ALLL would each
decline by $20 with no change in capital. If the bank conducts another
analysis of its loan collectibility and decides to add to its ALLL,
then its capital would be further reduced.
Figure 6: Illustration of How ALLL and Loan Losses Can Affect Capital
Ratios on a Bank's Balance Sheet:
[Refer to PDF for image: illustration]
Capital ratio = capital/assets:
Original with 1 percent allowance for loss:
Bank provides $10 for estimated loan losses in the ALLL, or 1% of its
loans held on balance sheet.
Loans: $1,010;
allowance: -$10;
Assets: $1,000.
Liabilities: $900;
Capital: $100;
capital ratio: 10%.
Revised with 3 percent allowance for loss:
After analyzing loan collectibility, bank raises ALLL to 3% of loans in
anticipation of greater losses. The increase in the ALLL (a charge to
expenses that reduces the retained earnings portion of capital) causes
net assets and the capital ratio to decline.
Loans: $1,010;
allowance: -$30;
Assets: $980.
Liabilities: $900;
Capital: $80;
capital ratio: 8.2%.
Revised with charge-off of $20 loan:
The bank charges off a $20 loan, identified as uncollectible in the
ALLL, bringing ALLL to $10.
Loans: $990;
allowance: -$10;
Assets: $980.
Liabilities: $900;
Capital: $80;
capital ratio: 8.2%.
Revised ALLL:
Bank analyzes loans for collectibility and raises the ALLL to $20 as a
result of greater estimated loan losses. The $10 increase in the ALLL
is charged to expenses, which reduces capital.
Loans: $990;
allowance: -$20;
Assets: $970.
Liabilities: $900;
Capital: $70;
capital ratio: 7.2%.
Source: GAO.
[End of figure]
For this example, if the bank decides to--or is required to--meet a 10
percent capital ratio after adding to its ALLL to cover estimated
future losses, it would need to raise capital by seeking it from the
bank's owners or from investors. If the bank cannot raise additional
capital because it is in poor financial condition, or chooses not to
because the cost of capital is prohibitive, then it could, among other
options, reduce its assets (perhaps by selling assets such as other
real estate owned) to decrease liabilities or by paying off borrowings
to increase the capital ratio. Reducing assets is often referred to as
"shrinking the balance sheet." However, banks in better financial
condition may be able to respond differently in the face of loan
losses--they may be able to continue lending without raising
additional capital or can rely on their stronger financial position to
secure new capital.
[End of section]
Appendix III: Comments from the Federal Deposit Insurance Corporation:
FDIC:
Federal Deposit Insurance Corporation:
Division of Risk Management Supervision:
550 I7th Street NW:
Washington, D.C. 20429-9990:
May 10, 2011:
Mr. Richard J. Hillman:
Managing Director:
Financial Markets and Community Investment:
United States Government Accountability Office:
411 G Street N.W.
Washington, D.C. 20548:
Dear Mr. Hillman:
The Federal Deposit Insurance Corporation (FDIC) reviewed the GAO
report "Banking Regulation: Enhanced Guidance on Commercial Real
Estate Risks Needed" (GA0-11-489). The FDIC agrees with the GAO's
conclusion that examiners applied the 2006 Commercial Real
Estate (CRE) concentration guidance[Footnote 1] (Guidance)
appropriately and their supervisory responses were accurate and well
supported. The FDIC also agrees with the GAO's conclusion that the
federal banking regulators have incorporated lessons learned from the
crisis into their supervisory approach.
The GAO recommended the federal banking regulators enhance or
supplement the Guidance and take steps to better ensure the enhanced
or additional guidance is applied consistently. While the severity of
the financial crisis exposed areas for regulatory focus, especially
with respect to the concentration of risk in CRE or other markets, the
FDIC has implemented additional supplemental supervisory strategies
that we believe supplement the existing Guidance.
The Guidance provides a robust process for bankers and examiners to
assess and monitor CRE portfolio risk and ensure banks are following
safe-and-sound lending practices. In 2008, the FDIC supplemented the
Guidance with a Financial Institution Letter (FIL), Managing
Commercial Real Estate (CRE) Concentrations in a Challenging
Environment, as it was apparent that significant risks were emerging
in CRE lending, particularly in the Acquisition Development and
Construction (ADC) sector. This FIL emphasized to financial
institutions the importance of CRE credit risk management, using
available loan workout resources, maintaining appropriate capital and
Allowance for Loan and Lease Losses levels, updating collateral
valuations, and making prudent CRE and ADC loans available in local
markets.
Furthermore, since the beginning of the economic crisis, the FDIC
applied a constructive and proactive approach to enhancing our
supervision program. The Division of Risk Management Supervision
conducted division-wide training during the first quarter 2010 to
emphasize the analysis of risk management practices, which focused on
analyzing CRE portfolio risk, and implementation of appropriate and
timely corrective action. The FDIC follows a comprehensive quality
assurance and internal review program to ensure examiners consistently
apply policies and guidance, including those applicable to CRE loan
concentrations.
The GAO's report cites the research of a pair of authors to suggest
that while higher bank capital requirements increase a bank's ability
to absorb losses, they also constrain its ability to lend.
Other studies by academic economists and the Bank for International
Settlements (BIS) have concluded that the effect of higher bank
capital requirements on banks' cost of capital and on borrowing costs
are modest. The BIS study concluded that the social cost of higher
bank capital requirements is far outweighed by the benefits in terms
of avoiding the large reductions in economic activity associated with
a banking collapse.
Thank you for the opportunity to review and comment on this Report.
Sincerely,
Signed by:
Sandra L. Thompson:
Director:
Footnote:
[1] Federal Deposit Insurance Corporation, Office of the Comptroller
of the Currency, and Board of Governors of the Federal Reserve System
joint Guidance on Concentrations in Commercial Real Estate Lending,
Sound Risk Management Practices, Federal Register December 12, 2006,
Volume 71, Number 238, 74580-74588.
[End of section]
Appendix IV: Comments from the Board of Governors of the Federal
Reserve System:
Board Of Governors of the Federal Reserve System:
Division of Banking Supervision and Regulation:
Washington, DC 20551:
May 6, 2011:
Ms. A. Nicole Clowers:
Director, Financial Markets and Community Investment:
U.S. Government Accountability Office:
Washington, DC 20548:
Dear Ms. Clowers:
Thank you for the opportunity to comment on the GAO's draft report
entitled Banking Regulation: Enhanced Guidance on Commercial Real
Estate Risks Needed. As the draft report acknowledges, the banking
agencies have taken a number of steps to encourage consistency and
balance in the implementation of Commercial Real Estate (CRE) guidance
by field examiners. These include extensive training for examiners,
issuance of clarifications and additional guidance, report-of-
examination review processes, and follow-up on questions and concerns
raised by bankers. We note that the report deemed these efforts to
provide reasonable assurance that the guidance was being carried out
as directed, and that the GAO found—in most cases reviewed—that
examiners were appropriately applying CRE guidance and supporting
their findings in reports of examination.
Nevertheless, we note that the GAO found instances of inconsistency in
the application of the guidance by all of the agencies, and that it
recognized additional work would help to enhance consistency. We note
that the report cites some specific suggestions from examiners and
bankers on where existing guidance could be enhanced or clarified. In
this regard, we welcome the report's two recommendations: (1) to
enhance CRE concentration guidance to help banks comply with CRE
concentration and risk management requirements and help examiners
ensure greater consistency in application of the guidance, and (2)
once enhancements are in place, to take steps within review-and-
quality-assurance procedures to ensure the enhanced guidance is
adhered to consistently. We concur that such initiatives would improve
implementation of CRE concentration standards by the agencies, and we
intend to work with our colleagues at the FDIC and OCC to develop and
implement such agreed-upon enhancements.
Sincerely,
Signed by:
Patrick M. Parkinson:
Director:
[End of section]
Appendix V: Comments from the Office of the Comptroller of the
Currency:
Comptroller of the Currency:
Administrator of National Banks:
Washington, DC 20219:
April 28, 2011:
Ms. A. Nicole Clowers:
Acting Director, Financial Markets and Community Investment:
United States Government Accountability Office:
Washington, DC 20548:
Dear Ms. Clowers:
We have received and reviewed your draft report titled "Banking
Regulation: Enhanced Guidance on Commercial Real Estate Risks Needed."
Your report responds to a Congressional request for a review of
examiners' practices related to commercial real estate (CRE);
regulators' views on bank ratings, capital and liquidity; and the
impact of regulatory practices on lending by community banks.
You found that: (1) deterioration of the CRE market negatively
affected community banks, which could impact small business lending;
(2) while regulators have taken steps to address CRE concentrations
and bank concerns, challenges remain in consistently applying
guidance; and (3) multiple factors can affect banks' lending
decisions, and regulators' actions may affect lending. You further
note that high concentrations in CRE exposures can inhibit banks'
ability to lend, especially during a credit downturn, and that
existing studies and interviews with bank officials suggest that
market factors drive CRE downturns and that the regulatory effect of
examiner actions on such downturns was minimal.
You recommend that the federal banking regulators enhance or
supplement the 2006 CRE concentration guidance and take steps to
better ensure that the enhanced or additional guidance is consistently
applied.
We agree with your conclusions and recommendations. We will discuss
with the other federal banking regulators areas where we believe the
2006 guidance could be enhanced or supplemented to address issues that
have arisen in the application of that guidance. As your report notes,
increased exposure to CRE has made community banks vulnerable to
declines in this market and has been a prevalent factor in recent bank
failures. Given these facts, the OCC believes there may be a need to
provide more clear and explicit expectations that as concentrations
increase, so must the level and robustness of risk management systems,
stress testing, capital planning, and capital levels. Through our
existing review and quality assurance processes, we will ensure that
any revised guidance is implemented consistently and that examination
conclusions are well-supported.
We appreciate the opportunity to comment on the draft report.
Sincerely,
Signed by:
John Walsh:
Acting Comptroller of the Currency:
[End of section]
Appendix VI: GAO Contact and Staff Acknowledgments:
GAO Contact:
A. Nicole Clowers, Acting Director (202) 512-8678 or ClowersA@gao.gov:
Staff Acknowledgments:
Kay Kuhlman, Assistant Director, and Robert Lee, Analyst-in-Charge,
managed this review. Emily Biskup and Jason Wildhagen also led
portions of the research and made significant contributions throughout
the report.
Anna Maria Ortiz and Rudy Chatlos provided methodological assistance
related to our nonprobability sample. Michael Hoffman provided
assistance reviewing the methodologies of our research studies and
assistance on capital-related issues. JoAnna Berry provided assistance
in identifying relevant research literature. Bill Cordrey, Jay Thomas,
and Gary Chupka provided accounting assistance. Paul Thompson provided
legal assistance. Marc Molino developed the report's graphics. Barbara
Roesmann provided editorial assistance. Jan Bauer, Kimberly Cutright,
Andrea Dawson, Nathan Gottfried, Elizabeth Jimenez, Angela Messenger,
Lauren Nunnally, Michael Pahr, Ellen Ramachandran, Maria Soriano,
Winnie Tsen, Gavin Ugale, and Carrie Watkins held various roles in
verifying our findings.
[End of section]
Footnotes:
[1] Throughout this report we define community banks as banks
regulated by a federal banking regulator that have $1 billion or less
in total assets. Commercial real estate includes rental apartment
buildings, industrial properties, office buildings, hotels, healthcare-
related properties, and retail properties such as shopping malls,
strip malls, and freestanding outlets.
[2] Capital generally is defined as a firm's long-term source of
funding, contributed largely by a firm's equity stockholders and its
own returns in the form of retained earnings. One important function
of capital is to absorb losses.
[3] The interagency statements and guidance they issued from 2006
through 2010 are: OCC, Federal Reserve, and FDIC, Concentrations in
Commercial Real Estate Lending, Sound Risk Management Practices, 71
Fed. Reg. 74580 (Dec. 12, 2006); FDIC, Federal Reserve, OCC, and the
Office of Thrift Supervision (OTS), Interagency Statement on Meeting
the Needs of Creditworthy Borrowers (Nov. 12, 2008); FDIC, Federal
Reserve, OCC, OTS, the National Credit Union Administration (NCUA),
and the Federal Financial Institutions Examination Council (FFIEC)
State Liaison Committee, Policy Statement on Prudent Commercial Real
Estate Loan Workouts (Oct. 30, 2009) (see for example, Federal Reserve
SR 09-07 and FDIC FIL-61-2009); and FDIC, Federal Reserve, OCC, OTS,
NCUA, and the Conference of State Bank Regulators, Interagency
Statement on Meeting the Credit Needs of Creditworthy Small Business
Borrowers (Feb. 12, 2010).
[4] Bank examiners review how banks internally classify their loans
and assign their own classification to a sample of loans reviewed
during an examination. The categories for classification are
substandard, doubtful, and loss. Having higher amounts of classified
loans can lead to required increases in reserves for future losses on
such loans. For more details, see the background section of this
report.
[5] All banks that FDIC insures submit quarterly Call Reports, which
contain a variety of financial information about a bank's condition
and income.
[6] FDIC, the Federal Reserve, and OCC supervise community banks that
hold the greatest amount of CRE loans. We did not include OTS or NCUA
in our analysis because their institutions hold a relatively small
amount of total loans in CRE loans.
[7] FFIEC was established on March 10, 1979, to prescribe uniform
principles, standards, and report forms for the federal examination of
financial institutions by FDIC, the Federal Reserve, OCC, NCUA, and
OTS.
[8] For this analysis, we considered a loan past due after 90 days.
Nonaccrual treatment of a loan indicates that the loan is not likely
to recover full principal and interest, and therefore the bank cannot
recognize the interest it may receive on the loan as income. According
to FFIEC call report instructions, generally an asset is to be
reported as being in nonaccrual status if: (1) it is maintained on a
cash basis because of deterioration in the financial condition of the
borrower, (2) payment in full of principal or interest is not
expected, or (3) principal or interest has been in default for a
period of 90 days or more unless the asset is both well secured and in
the process of collection.
[9] Concentrations in Commercial Real Estate Lending, Sound Risk
Management Practices sets thresholds for CRE and ADC concentrations,
and requires banks to have certain risk-management systems in place to
address high concentrations. ADC is considered a risky form of CRE, as
it includes loans for constructing and developing commercial real
estate projects. We discuss the types of CRE loans and their risks in
greater detail in the background section of this report.
[10] See appendix I for additional details on our scope and
methodology.
[11] See GAO, Financial Regulation: A Framework for Crafting and
Assessing Proposals to Modernize the Outdated U.S. Financial
Regulatory System, [hyperlink, http://www.gao.gov/products/GAO-09-216]
(Washington, D.C.: Jan. 8, 2009).
[12] Total capital consists of the sum of tier 1 and tier 2 capital.
Tier 1 capital consists primarily of tangible equity. Tier 2 capital
includes subordinated debt, a portion of loan loss reserves, and
certain other instruments.
[13] These CAMELS definitions are shared among the federal bank
regulators; we have excerpted them from the Federal Reserve's
Commercial Bank Examination Manual.
[14] The regulatory definition of ALLL is the "general valuation
allowances that have been established through charges against earnings
to absorb losses on loans and lease financing receivables." 12 CFR
325.2.
[15] A charge-off occurs when a bank recognizes that a particular
asset or loan will not be collectible and must be written off. This
loss is removed from the reserve, or ALLL (which is replenished from
income).
[16] These definitions are from Concentrations in Commercial Real
Estate Lending, Sound Risk Management Practices.
[17] For more information, see E. Philip Davis and Haibin Zhu, "Bank
Lending and Commercial Property Cycles: Some Cross-Country Evidence,"
Journal for International Money and Finance 30, no. 1 (2010).
[18] Securitization is a process in which financial assets (such as
loans) are brought together into interest-bearing securities that are
sold to investors. CMBS are backed by mortgages for CRE, such as
apartment and office buildings, industrial properties, hotels, and
retail properties. CMBS are sensitive to underlying CRE prices and the
cash flow generated from the properties backing the mortgages.
[19] GAO, Troubled Asset Relief Program: Treasury Needs to Strengthen
Its Decision-Making Process on the Term Asset-Backed Securities Loan
Facility, [hyperlink, http://www.gao.gov/products/GAO-10-25],
(Washington, D.C.: Feb. 5, 2010).
[20] Sam Chandan, Real Capital Analytics, "Commercial Real Estate and
Capital Markets Outlook," presentation at FFIEC's Supervisory Updates
and Emerging Issues conference in Washington, D.C., on October 20,
2010.
[21] Mortgage Bankers Association, Commercial Real Estate/Multifamily
Finance Quarterly Databook: Third Quarter 2010 (Washington, D.C.: Dec.
21, 2010).
[22] Moody's Investors Service, "U.S. CMBS: Moody's CMBS Delinquency
Tracker" (New York: Feb. 14, 2011).
[23] See E. Philip Davis and Haibin Zhu, "Bank Lending and Commercial
Property Cycles."
[24] Although there are 106 MLR reports, they address findings on 109
banks.
[25] GAO, Troubled Asset Relief Program: Status of Programs and
Implementation of GAO Recommendations, [hyperlink,
http://www.gao.gov/products/GAO-11-74] (Washington, D.C.: January
2011).
[26] Bank for International Settlements, "Cycles and the Financial
System," in 71st Annual Report (2001): 126.
[27] In 2008, the average net portion of the quarterly survey's
respondents who said that they were tightening standards for CRE loans
was 81.7 percent. This trend of tightening underwriting standards
continued in 2009 and 2010, although at a decreased rate. The average
net portion of the quarterly survey's respondents in 2009 who reported
tightening standards for CRE loans was 56.4 percent, decreasing to an
average of 12.2 percent in 2010.
[28] Concentrations in Commercial Real Estate Lending, Sound Risk
Management Practices, Proposed Guidance, 71 Fed. Reg. 2302 (Jan. 13,
2006).
[29] 71 Fed. Reg. 74580 (Dec. 12, 2006). The guidance focuses on CRE
loans that are sensitive to conditions in the general CRE market, such
as market demand, changes in vacancy rates, and other factors. Based
on the approach in the guidance, CRE primarily consists of loans
secured by land and development construction, multifamily property,
and nonfarm nonresidential property (where the primary source of
repayment is derived from rental income associated with the property
or the proceeds of the sale, refinancing, or permanent financing of
the property). Also included are loans to real estate investment
trusts and unsecured loans to developers. Excluded from this
definition are loans secured by nonfarm nonresidential properties
where the primary source of repayment is the cash flow from the
ongoing operations and activities conducted by the party that owns the
property.
[30] 71 Fed. Reg. at 74584, 74587.
[31] Policy Statement on Prudent Commercial Real Estate Loan Workouts
(Oct. 30, 2009).
[32] The 2009 CRE loan workout guidance states the following about
identifying a TDR: "a restructured loan is considered a TDR when the
institution, for economic or legal reasons related to a borrower's
financial difficulties, grants a concession to the borrower in
modifying or renewing a loan that the institution would not otherwise
consider. To make this determination, the lender assesses whether (a)
the borrower is experiencing financial difficulties, and (b) the
lender has granted a concession."
[33] GAO, Standards for Internal Control in the Federal Government,
[hyperlink, http://www.gao.gov/products/GAO/AIMD-00.21.3.1]
(Washington, D.C.: November 1999).
[34] FFIEC, working with FDIC officials, also introduced a course on
CRE loan workouts to supplement existing courses on CRE for
commissioned examiners across the banking regulators. Examiners
typically are commissioned after they complete professional training
and pass tests to measure their proficiency. FFIEC courses are geared
toward commissioned examiners from the federal banking regulators and
some state regulators.
[35] For example, FDIC headquarters conducts periodic reviews of its
regions. The reviews can focus on issues such as the region's
timeliness, effectiveness, risk assessment, communication, and systems
and also may focus on particular risk areas identified in a region. At
the Federal Reserve, the Federal Reserve Board and Reserve Banks
conduct a number of internal reviews. First, the Federal Reserve Board
reviews certain operations of the Reserve Banks, including risk-
focused reviews of each supervision department about every 3 years.
Second, each Reserve Bank has a General Auditor who conducts audits of
the Supervision and Regulation function about every 3 years. The
audits tend to focus on processes and controls. Third, the Reserve
Banks have a Quality Assurance function that conducts periodic reviews
on whether Supervision and Regulation is executing its
responsibilities according to Federal Reserve Board policy guidance.
[36] Of FDIC's six regions, we reviewed the most recent FDIC internal
review reports for four (Atlanta, Dallas, New York, and San Francisco).
[37] The Federal Reserve districts that conducted this review are
Atlanta, Kansas City, Philadelphia, and Richmond.
[38] This official clarified that the sample of loans was small
because he only reviewed downgraded CRE loans, and the volume of
downgraded loans in recent ROEs was small.
[39] As part of this process, the districts categorized banks based on
their CRE-related risks and reviewed CRE loan classifications for
banks that presented the greatest risks. In some cases, this process
resulted in changes to loan classifications before the ROE was
finalized. We reviewed the reports that all of OCC's districts
produced from their quality assurance processes.
[40] OCC could not provide comparable quantitative results for the
southern or northeastern districts.
[41] Each survey is used for different purposes. For example, FDIC
issues a survey after safety and soundness examinations to seek input
from banks to improve the efficiency and effectiveness of the
examination process. Other surveys are issued to respond to specific
information needs, as discussed above.
[42] The ombudsman offices provide confidentiality, as required by
law, and must follow up on any concerns that banks have about
potential retaliation from the issues that they have raised with the
ombudsman, as detailed in the Riegle Community Development and
Regulatory Improvement Act of 1994, Pub. L. No. 103-325 § 309(d), 12
U.S.C. § 4806(d).
[43] Throughout the report, we avoid providing specific numbers of
bank officials making certain statements to avoid overstating the
precision of the results from the nonprobability sample we selected.
For information on how we use the terms "a few," "some," and "many,"
see appendix I.
[44] In addition, FDIC in March 2011 sent out a reminder to banks
about the ways they can contact regulatory officials, and encouraged
them to discuss examination concerns. FDIC Financial Institution
Letter FL-13-2011, March 1, 2011.
[45] For more details on how we identified these banks for interviews,
see appendix I. Because we selected a nonprobability sample, these
banks' views are not representative of all banks in the country.
[46] The amount of allowance that a bank provisions in anticipation of
potential losses is determined by calculations performed under two
accounting standards, Accounting Standards Codification (ASC) 450,
Contingencies (formerly FAS 5) and ASC 310-40 (formerly FAS 114).
Under ASC 450, segments of the loan portfolio are evaluated on the
basis of risk factors such as historical losses, delinquencies and
nonaccruals, and concentrations of credit, among other factors. A
determination on expected loss rates is made for each loan segment
based on the relevant risk factors. Under ASC 310-40, a bank must
identify for individual review loans that have been determined to be
impaired. The bank should provision for the difference between the
book value and the determined market value. The sum of the ASC 450 and
310-40 calculations is the total ALLL.
[47] For additional details on how loan classifications and increased
provisions for loan losses affect ALLL, see appendix II.
[48] Specifically, bankers told us that some examiners were using tier
1 capital plus ALLL as the denominator for calculating the
concentration, rather than total capital as described in the guidance.
[49] The IGs for FDIC, the Federal Reserve, and Treasury (for OCC and
OTS) are required to perform an MLR to determine the cause of bank
failures that result in a material loss to the Deposit Insurance Fund
and assess the quality of regulatory supervision preceding the
failure. See 12 U.S.C. § 1831o(k). Before the Dodd-Frank Wall Street
Reform and Consumer Protection Act of 2010, the IGs were required to
conduct these reviews when the Deposit Insurance Fund experienced a
loss exceeding the greater of $25 million or 2 percent of the bank's
assets at the time of FDIC assistance. In the act, Congress amended
the provision by increasing the MLR threshold so that it is based on
estimated losses exceeding specified amounts. Under the act, IGs are
required to conduct MLRs when losses to the Deposit Insurance Fund
exceed $200 million during the period from January 1, 2010, to
December 31, 2011. This threshold decreases over time to $50 million
on or after January 2014. The act also requires the IGs to review all
other losses incurred by the Deposit Insurance Fund to determine (a)
the grounds identified by the bank's regulator for appointing FDIC as
receiver and (b) whether any unusual circumstances exist that might
warrant an in-depth review of the loss. Pub. L. No. 111-203 § 987.
[50] For additional details, see GAO, Financial Regulation: Review of
Regulators' Oversight of Risk-management Systems at a Limited Number
of Large, Complex Financial Institutions, [hyperlink,
http://www.gao.gov/products/GAO-09-499T] (Washington, D.C.: Mar. 18,
2009).
[51] The findings of the Financial Crisis Inquiry Commission mirror
some MLR findings in stating that leading up to the financial crisis,
regulators had tools at their disposal to address growing risks in the
financial system but did not always choose to use them. For example,
regulators' bank ratings continued to reflect that they were safe and
sound, and regulators downgraded ratings only immediately before the
banks failed. The report also includes testimony from the Federal
Reserve's former director of Banking Supervision and Regulation that
prior to the financial crisis, regulatory intervention before a bank
showed poor financial performance could have been considered "overly
intrusive" or "heavy-handed." See Financial Crisis Inquiry Commission,
The Financial Crisis Inquiry Report: Final Report of the National
Commission on the Causes of the Financial and Economic Crisis in the
United States (Washington, D.C.: January 2011).
[52] For more information on our nonprobability sampling of banks for
interviews and ROE analysis, see appendix I.
[53] Of the 7 ROEs, 1 was conducted by the Federal Reserve (of 12
Federal Reserve examinations we reviewed); 3 by OCC (of 22 OCC
examinations), and 3 by FDIC (of 21 FDIC examinations). Two were for
banks in California, one in Georgia, and four in Texas. Note that the
sample we selected cannot be extrapolated to the universe of
examinations and, therefore, cannot be used to draw conclusions about
potential differences among regulators or among banks in certain
states.
[54] In two other ROEs, the examination states that the bank must
reduce CRE concentrations and the enforcement action also requires at
least consideration that concentrations be reduced--although the
enforcement action also emphasizes the need for improvements to the
bank's risk-management systems.
[55] Specifically, 10 ROEs use only tier 1 capital or tier 1 capital
plus ALLL. Another 13 use tier 1 and also provide concentrations as a
percent of "capital," but the ROEs are unclear on the form of capital.
Thirteen ROEs use total risk-based capital, equity capital, or capital
alone. Eleven ROEs use total risk-based capital with tier 1 capital
plus ALLL. Eight ROEs either do not provide a concentration or do not
clearly articulate how it was calculated.
[56] For more details on whom we interviewed, see appendix I. The
views of this particular group of examiners and officials cannot be
generalized to the population of all examiners or officials.
[57] For additional details on the potential impact of capital and
ALLL on a bank's ability to lend, see appendix II.
[58] Joe Peek and Eric S. Rosengren, "Bank Regulatory Agreements in
New England," New England Economic Review (May/June 1995): 1-2.
[59] Joe Peek and Eric S. Rosengren, "The Capital Crunch in New
England," New England Economic Review (May/June 1992): 9.
[60] During the crisis, the average estimated growth rate of non-CRE
loans at low-and mid-CRE banks was "positive and around 1 percent."
However, during the crisis banks with high CRE concentrations
decreased non-CRE lending "on average, by 0.5 percentage points per
quarter." These changes led to a "nearly $82 billion cumulative
increase in non-CRE loans at low-and mid-CRE banks…and about a $15
billion decline in non-CRE loans at high-CRE banks." "Low-CRE banks
and mid-CRE banks" are based on the ratio of CRE loans to total assets
right before the onset of the crisis (second quarter of 2007). The
bank holding companies were categorized into three groups: high-CRE
banks (top 30 percent), mid-CRE banks (30 to 69 percent), and low-CRE
banks (bottom 30 percent). Sumit Agarwal, Hesna Genay, and Robert
McMenamin (Federal Reserve Bank of Chicago), "Why Aren't Banks Lending
More? The Role of Commercial Real Estate," Chicago Fed Letter 281
(2010): 1-4. This paper measures changes in loan growth based on
changes in total loan assets measured in bank call reports. As we
previously have reported, this approach is limited because reductions
in total loan balances can be explained by charge-offs and loan
payoffs and do not therefore provide an ideal measure of new loan
originations. For more information, see GAO, Troubled Asset Relief
Program: Treasury's Framework for Deciding to Extend TARP Was
Sufficient, but Could Be Strengthened for Future Decisions, GAO-10-531
(Washington, D.C.: June 30, 2010).
[61] In this article, supervisory "toughness" refers to "treating
banks of a given financial condition more harshly than in previous
years." Allen N. Berger, Margaret K. Kyle, and Joseph M. Scalise, "Did
U.S. Bank Supervisors Get Tougher during the Credit Crunch? Did They
Get Easier during the Banking Boom? Did It Matter to Bank Lending?"
National Bureau of Economic Research Working Paper Series 7689
(Cambridge, Mass.: 2000): 1.
[62] We use "CAMEL" in this instance, because that is the term the
authors used in the article. See Berger, Kyle, and Scalise, "Did U.S.
Bank Supervisors Get Tougher during the Credit Crunch?"
[63] We use "CAMEL" in these instances, because that is the term the
authors used in the article. Timothy J. Curry, Gary S. Fissel, and
Carlos D. Ramirez, "The Impact of Bank Supervision on Loan Growth,"
North American Journal of Economics and Finance 19 (2008): 113-134.
[64] The tables on pp. 125-130 report aggregate loan growth
regressions for three loan categories: commercial and industrial loans
(C & I), consumer loans, and real estate loans over two distinct
periods: 1985-1993 (first period) and 1994-2004 (second period).
Explanatory variables included: (a) first and second lagged dependent
variables (loan growth); (b) changes in CAMEL rating (first and second
lags); (c) changes in SCOR rating (first and second lag); (d) state
output growth (first and second lags). As a group, the tables show a
consistent set of results; in all tables (composite CAMEL ratings and
components) downgrades are associated with a decline in C&I lending in
the first period, but not in the second. In virtually all regressions,
the estimated coefficient ranges from about -0.4 to about -0.8 in the
short run and the long run. The same is not true, for the most part,
for consumer lending or real estate lending. Curry, Fissel, and
Ramirez, "The Impact of Bank Supervision on Loan Growth."
[65] A recent memorandum attached to a report from FDIC's IG suggests
this when stating that one of FDIC's primary challenges will be to
continue its Forward Looking Supervision program even into the next
economic recovery period. For the report itself, see FDIC, Office of
Inspector General, Follow-up Audit of FDIC Supervision Program
Enhancements, MLR-11-010 (Arlington, Va.: Dec. 23, 2010).
[66] Discussions on capital requirements among banks and regulators
recognize that capital requirements can impact lending--although there
is disagreement on the magnitude of that impact. For example,
according to an analysis by the Bank for International Settlements, a
4 percentage point increase in the risk-based capital ratio would
increase loan interest rates by 60 basis points. In contrast, the
Institute for International Finance estimates that a 4 percentage
point increase in the risk-based capital ratio would increase loan
interest rates by 136 basis points. Therefore, it appears that capital
requirements can affect lending, but the severity of such impacts is
not completely settled. See Basel Committee on Banking Supervision, An
Assessment of the Long-term Economic Impact of Stronger Capital and
Liquidity Requirements (Basel, Switzerland: August 2010) and two
reports from the Institute of International Finance: Interim Report on
the Cumulative Impact on the Global Economy of Proposed Changes in the
Banking Regulatory Framework (Washington, D.C.: June 2010) and The Net
Cumulative Economic Impact of Banking Sector Regulation: Some New
Perspectives (Washington, D.C.: October 2010).
[67] FASB, "Accounting for Financial Instruments and Revisions to the
Accounting for Derivative Instruments and Hedging Activities,"
proposed accounting standards update issued on May 26, 2010.
[68] FDIC, the Federal Reserve, and OCC supervise community banks that
hold the most amount of CRE loans. We did not include Office of Thrift
Supervision or National Credit Union Administration in our analysis
because their institutions hold a relatively small amount of their
total loans in CRE loans.
[69] CAMELS encompass Capital adequacy, Asset quality, Management,
Earnings, Liquidity, and Sensitivity to market risk. As discussed
earlier in this report, in examinations a bank is rated for each of
the CAMELS components and given a composite rating, which generally
bears a close relationship to the component ratings. However, the
composite is not an average of the component ratings. The component
rating and the composite ratings are scored on a scale of 1 (best) to
5 (worst).
[70] For this analysis, we considered a loan past due after 90 days.
Nonaccrual treatment of a loan indicates that the loan is not likely
to recover full principal and interest, and therefore the bank cannot
recognize the interest it may receive on the loan as income. According
to call report instructions from the Federal Financial Institutions
Examination Council (FFIEC), generally an asset is to be reported as
being in nonaccrual status if: (1) it is maintained on a cash basis
because of deterioration in the financial condition of the borrower,
(2) payment in full of principal or interest is not expected, or (3)
principal or interest has been in default for a period of 90 days or
more unless the asset is both well secured and in the process of
collection.
[71] One ROE in our sample was completed before the guidance was
issued in its final form, but it refers to the 2009 guidance, and
therefore we included it because it was relevant to our work.
[72] This example is simplified to clarify the relationships between
assets and capital.
[End of section]
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